What do U.S. life insurers invest in?;

What do U.S. life insurers invest in?

by Robert McMenamin, senior research analyst, Anna Paulson, vice president and director of nancial research, Thanases Plestis,

associate economist, and Richard Rosen, senior nancial economist

Researchers at the Chicago Fed Insurance Initiative are analyzing the role that the insurance

industry plays in financial markets and the economy as a whole. This article presents an

overview of life insurers’ financial asset holdings, the industries they invest in, and how the

value of their investments would change if there was a large negative shock to asset values.

Chicag o Fed Letter

ESSAYS ON ISSUES THE FEDERAL RESERVE BANK APRIL 2013

OF CHICAGO NUMBER 309

U.S. life insurance companies own more

than $5.5 trillion dollars in real and -

nancial assets and provide funding to

other sectors of the economy through

their investment activities. For example,

life insurers own 6.0% of all outstanding

credit market instruments in the U.S.

Life insurers invest premiums that they

receive from customers. They generally

choose assets with features that are aligned

with the characteristics of the insurance

products that they sell. For example,

proceeds from a long-term insurance

product would be invested in a long-

duration asset. This means that the risks

from insurance liabilities will generally

be balanced by the risks insurers assume

through their investment activities.

At a fundamental level, life insurance

companies sell products to satisfy two

types of long-term demand. Some cus-

tomers want protection from adverse

nancial consequences resulting from

loss of life (life insurance) or from the

exhaustion of nancial resources over

time (annuities). Other customers seek

to earn a return on their premiums that

can be withdrawn in the future (annuities

meet this demand). Because customers

often make claims on and withdrawals

from their policies years after they have

been issued, life insurers face the chal-

lenge of investing customer payments

to ensure they will have sufcient funds

available to satisfy claims and withdrawals

in the distant future. This generally leads

life insurers to invest in a collection of

long-term assets.

Life insurance company asset holdings

Figure 1 presents a breakdown of the

assets held by the life insurance industry.

As the gure shows, life insurers segre-

gate their assets (and, by extension,

their liabilities) into two independent

“accounts” on their balance sheets—the

general account and the separate account.

General-account assets support liabilities

that feature guaranteed returns to cus-

tomers from the insurer. In contrast,

separate-account assets support “pass-

through” products, in which investment

gains and losses are passed on to the

customer and no more than a minimum

return may be guaranteed.

Typical

general-account products include term

life insurance, whole life insurance, xed

annuities, and disability insurance. Prod-

ucts whose payouts uctuate based on

the investment environment include

variable annuities and variable life in-

surance. The assets that back these

products are recorded on the separate

account. The industry’s aggregate gen-

eral account held $3.53 trillion in assets

at the end of 2011, roughly double the

$1.84 trillion in assets held in the separate

account (see gure 1). The assets held

in the two accounts were very different.

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the Insurance Initiative,

visit www.chicagofed.org/

webpages/markets/

insurance_initiative.cfm

In the general account, xed-income

assets like bonds and mortgages consti-

tuted the largest share of invested assets,

at 75.5% and 9.6%, respectively. Separate-

account assets comprised primarily equi-

ties. Only 14.3% of separate-account

invested assets were bonds, and mort-

gages made up only 0.5%. We focus our

attention on general-account assets be-

cause life insurers typically do not pass

investment gains and losses on these

assets to their customers, so they must

manage the associated valuation risk.

Corporate bonds make up the largest

share of general-account assets. Insurers

had $1.5 trillion of corporate bonds at

the end of 2011, and corporate bonds

accounted for 46.0% of all general-account

invested assets (see gure 1). As a major

corporate bond investor, the life insur-

ance industry represents an important

source of funding for U.S. corporations.

Corporate bonds issued by industrial

and manufacturing rms and nancial

rms each comprised about 27% of all

corporate bonds held by insurers (see

gure 2). No other industry accounted

for more than 10% of insurer corporate

bond holdings.

The recent global nancial crisis was

characterized by problems with nancial

rms and real estate. To measure the life

insurance industry’s exposure to these

areas, we compare their holdings with

the total credit market instruments out-

standing in these sectors. Overall, 29.6%

of corporate bonds in 2011 were issued

by nancial rms.

This share is compa-

rable to the sector’s share of insurers’

holdings at 26.7%.

Insurers’ exposure to real estate comes

through mortgage-backed securities

(MBS) (14.8% of insurers’ invested

assets), mortgage loans (9.6%), and

real estate owned (0.6%).

Therefore,

we look at real estate as a share of total

credit market instruments. The 25.0%

of total real-estate-related holdings on

insurers’ general account is somewhat

less than the sector’s 38.7% share of all

outstanding credit market instruments.

This suggests that insurers are not over-

exposed to this market sector. However,

it is important to keep in mind that dif-

ferent real-estate-related investments have

different risk proles. For example, mort-

gage loans have direct to real estate risk,

whereas MBS investments have indirect

exposure. MBS issued by government-

sponsored agencies, such as Fannie Mae

or Freddie Mac, or guaranteed by Ginnie

Mae, are guaranteed against defaults,

so they are subject to prepayment risk

(the risk that loans are paid off early).

Nonagency MBS have default risk as

well as prepayment risk.

Asset-valuation risk

The nancial crisis provided a power-

ful demonstration that asset values can

decline quickly. Some of the asset classes

heavily favored by insurers, especially

nonagency MBS, experienced major

losses during the crisis. We estimate the

potential decrease in the value of insurer

assets from an extreme downturn in

asset markets using data on market prices

for a variety of nancial instruments

1. Life insurance industry aggregate assets

General-account Separate-account

(GA) assets (SA) assets

Dollars % of GA Dollars % of SA

in billions investments in billions investments

Bonds 2,536.3 75.5 257.9 14.3

Corporate and foreign bonds 1,546.2 46.0 – –

Nonagency MBS 247.9 7.4 – –

ABS 171.5 5.1 – –

Treasury and federal government bonds 263.6 7.8 – –

Agency MBS 249.5 7.4 – –

State and municipal bonds 38.7 1.2 – –

Affiliated bonds 18.8 0.6 – –

Mortgage loans 323.1 9.6 9.6 0.5

Policy loans 126.0 3.7 0.5 0.0

Cash and short-term investments 96.5 2.9 18.4 1.0

Equities 78.4 2.3 1,448.9 80.1

Derivatives 44.4 1.3 1.0 0.1

Real estate 20.6 0.6 6.7 0.4

Other investments 135.3 4.0 65.7 3.6

Total invested assets 3,360.5 100.0 1,808.7 100.0

Total assets 3,534.4 – 1,835.6 –

Source: Authors’ calculations based on 2011:Q4 data from SNL Financial.

2. Life insurance corporate bond holdings by industry

NoteS: Data are as of 2012:Q3. Bonds that are missing an industry classification are excluded.

SourceS: Authors’ calculations based on statutory data from SNL Financial, Mergent Financial, and Standard & Poor’s.

Foreign

Utility

Transportation

Retail and wholesale trade

Service/leisure

Media and communications

Mining, oil, and gas

Finance

Manufacturing

0% 5% 10% 15% 20% 25% 30%

Banking

Insurance

Other finance

5.3%

10.2%

17.2%

1.7%

2.7%

4.1%

5.1%

7.1%

8.1%

27.2%

11.2%

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, nancial

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, nance 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.

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3. Estimated one-month-in-60 loss by asset class

Loss that occurs one

month in every 60 months

(percent)

Bonds 6.5

Corporate and foreign bonds 6.9

Nonagency MBS 28.2

ABS 8.0

Treasury and federal government bonds 5.7

Agency MBS 2.6

State and municipal bonds 4.2

Affiliated bonds 17.5

Mortgage loans 28.2

Policy loans 0.0

Cash and short-term investments 0.0

Equities 10.0

Derivatives 17.5

Real estate 28.2

Other investments 17.5

Total invested assets 7.8

SourceS: Authors’ calculations based on statutory data from SNL Financial, Haver

Analytics, and Bloomberg Financial. For specific indexes, see box A.

over the period from October 2002

through December 2012.

We use the distribution of life insurer in-

vestments in combination with data on

price uctuations to estimate the poten-

tial downside risk from changes in asset

prices. To do this, we match asset classes

to price indexes that are likely to track

the value of those assets closely and use

the performance of the index to estimate

the performance of the matched asset

class (see box A for details on the match-

ing process). For each day in the sample

period, we calculate the change in each

price index over the past month. We also

calculate the past-month change for a

weighted average of the indexes, where

the weights are the shares of the matched

asset classes from the aggregate life in-

surance balance sheet. We then compute

the standard deviations of these changes

and estimate the loss in value that occurs

with a particular frequency. We focus on

a loss that would occur one month in

every 60 months, or once in ve years.

This corresponds to a 2.13 standard devi-

ation price change. It is important to note

that we are estimating a loss in market

value, not in book value. Much of the

change in market value for xed-income

assets, such as bonds, is due to changes

in interest rates.

The once-in-ve-years losses vary across

asset categories (see gure 3). At the high

end, nonagency MBS are estimated to

lose 28.2% in market

value. In contrast, the

corporate bond port-

folio is estimated to

lose 6.9%. The once-

in-ve-years loss for

life insurance assets as

a whole is estimated to

be 7.8%, reecting

some benets from

diversication. Note

that the historical peri-

od that we analyze in-

cludes the nancial

crisis, so the estimates

of potential losses may

somewhat overstate the

risk going forward.

Then again, the peri-

od leading up to the

crisis, which is also in-

cluded in the data, was a period of un-

usual calm in nancial markets.

Our back-of-the-envelope calculations

suggest that a severe shock to asset prices

could reduce the value of the industry’s

investments by 7.8%, or $280 billion, using

third-quarter 2012 data. This corresponds

to an 86% loss in total industry equity,

which is $325 billion.

However, because

insurers make investments to match lia-

bilities, these losses would be partially

offset by gains on insurance liabilities.

To gauge the extent to which losses would

be offset, we calculate a once-in-ve-year

loss in life insurance equity using the

SNL Life Insurance stock index over the

2002 to 2012 period. This loss is 22.8%,

suggesting that 74% of the hypothetical

loss in assets from a severe price shock

would be offset by gains on insurance

liabilities.

Of course, this industry per-

spective may mask considerable variation

at the individual rm level. Some insur-

ance companies will have greater expo-

sure to riskier asset classes and others will

have less. Firms will also vary in the ex-

tent to which their liability gains would

offset their losses on investments. Simi-

larly, equity cushions differ across rms.

Conclusion

We have shown that life insurers invest

in a wide variety of nancial assets. Cor-

porate bonds make up the largest share

of their assets. Although insurers invest

in a diverse set of industries, they have

signicant investments in industrial and

manufacturing rms, nancial rms, and

real-estate-related securities. A severe

shock to asset prices would reduce the

value of life insurers’ asset holdings con-

siderably. However, our calculations

suggest that a signicant portion of the

losses on assets would be offset by gains

on liabilities.

 Based on 2012:Q3 data from the Board

of Governors of the Federal Reserve System,

2012, Flow of Funds Accounts of the United

States, statistical release, Washington,

DC, December 6, available at

www.federalreserve.gov/releases/z1/

Current/z1.pdf. Examples of credit market

instruments include Treasury securities,

mortgage-backed securities and mortgages,

municipal securities, corporate and foreign

bonds, consumer credit, and depository

institution loans.

 Not all gains and losses on separate-account

assets are necessarily passed on to customers.

Separate-account liabilities often include

embedded guarantees. These guarantees

are claims against the general account, and

are therefore supported by general-account

assets. These guarantees are more likely to

be triggered when interest rates have de-

clined sharply and when equity returns are

very low. We do not address potential risks

from embedded guarantees in this article.

Box A. Details on estimating asset risk

Indexes used

Corporate bonds: Bank of America, Merrill Lynch, U.S. corporate bond yields. A, BBB, BB, B, CCC, and lower-rated indexes are matched to similarly rated bonds.

Nonagency MBS: Morgan Stanley, U.S. fixed rate, CMBS conduit five-year spread. AAA, AA, A, and BBB are matched to similarly rated MBS.

ABS: Bank of America, Merrill Lynch, U.S. bond yields, asset-backed securities fixed-rate index.

Agency MBS: Equal-weighted blend of Merrill Lynch mortgage-backed securities, Ginnie Mae, Fannie Mae, and Freddie Mac indexes.

Treasury bonds: One-, three-, six-month and one-, two-, three-, five-, seven-, ten-, 20-, and 30-year Treasury yields for similar-maturity bonds.

Municipal bonds: Bank of America, Merrill Lynch, U.S. bond yields, municipals (tax-exempt) master index.

Equities: S&P 500 index for common stock and S&P preferred stock index for preferred stock.

Index values were provided by Haver Analytics and Bloomberg. When necessary, we convert yields to prices assuming a par value of 100, coupon rate as a one-

month lag of the yield, and a ten-year average maturity if no maturity is disclosed for the index. When multiple indexes are listed for a category, we weight by the

share of each item on the aggregate life insurance industry balance sheet except as noted.

In addition:

• We assume that the returns for corporate bonds and foreign bonds are similar, since we do not have a foreign bond index.

• We assume that standard deviations of returns for each ratings class of private corporate bonds are 1 percentage point higher than the corresponding returns

for public corporate bonds, since we do not have a private corporate bond index.

• We assume that the returns for nonagency commercial mortgage-backed securities (CMBS) and nonagency residential mortgage-backed securities (RMBS)

are similar, since we do not have a nonagency RMBS index.

• We assume that affiliated bonds have returns equal to the smallest daily return across the other categories of bonds.

• We assume that the returns for mortgage loans and real estate are similar to the returns for CMBS.

• We assume that policy loans and cash retain 100% of their value at all times. Policy loans are loans originated to policyholders that are financed by cash that

has accrued in their policies. They do not depreciate in value because failure to repay a policy loan results in termination of the policy.

• We assume that derivatives and other investments have returns equal to the smallest daily return across the other categories of assets.

 According to the Board of Governors of

the Federal Reserve System (2012), life

insurers owned 17.8% of all corporate and

foreign bonds as of 2012:Q3. (Note that

this source classies nonagency mortgage-

backed securities as corporate bonds while

we do not.)

Board of Governors of the Federal Reserve

System (2012). Financial rms exclude

asset-backed securities and real estate

investment trusts.

MBS includes nonagency MBS and agency

MBS, as reported in gure 1.

Board of Governors of the Federal Reserve

System (2012).

Insurance companies do a much more ex-

tensive set of stress tests that examine the

sensitivity of their capital to shocks in asset

and interest rate markets, among other

scenarios. In our example, we examine one

particular stress at the industry (rather than

rm) level.

According to 2012:Q3 data from SNL

Financial and authors’ calculations.

See note 8.