The impact of the financial crisis on insurers performance

In this section, we evaluate the extent to which the financial crisis of the period 2007–2009 affected insurance companies across the globe and compare insurers’ performance with that of banks during the same period.

Our aim is to compare performance in terms of returns during this time and also to evaluate firm valuations for the period leading up to and through the crisis. We also wish to gain a greater understanding of the correlation between these two markets and identify factors that might condition their relationship.

In a recent study, Parsons and Mutenga15 analysed changes in insurance company valuations during the crisis on an annual basis. While this methodology is plausible, it fails to capture instantaneous daily changes in performance brought about by the impact of new information, and hence our focus on daily returns in this paper.

The methodology used is quite simple in that it focuses on daily returns in major global banking and insurance indices. Data used in computing daily returns was obtained from Bloomberg and AM Best databases.

The choice of each index for inclusion in this analysis was based on two things, completeness of data and liquidity (measured by the volume of trade on the indices) for the period of study. Daily returns

for the period 2004–2009 for the Bloomberg indices and 2006–2010 for the AB Best Indices were computed by taking the natural logarithms of index values for year t, andt.

As regards the Bloomberg index, the period 2004–2009 was chosen because it represents the timeline for the financial crisis and also includes some major catastrophic events experienced by the insurance industry in the preceding years.

The choice of the study period for the AM Best indices was necessarily shorter, as these indices were

first introduced only in 2006. However, the AM Best indices bring an extra dimension to our study because they track global reinsurance stocks as well as Asia-Pacific insurers.

The underlying assumption is that insurer equity valuations and returns are determined by investment, underwriting and capital management policies adopted by each market. Therefore, any differences in performance observed across the markets can be construed as the result of investment, underwriting and capital management policies adopted.

Our study distinguishes between life, general and reinsurance companies, and aims to capture

and compare performance based on the business models adopted in each sector. Since our main remit is to analyse insurance company performance during the financial crisis, we do not make a distinction between banks with different types of structure.

In any event, there is no index dedicated to banks that, for example, have significant insurance interests. We believe our results to be robust as they capture the effects of underlying economic variables associated with the financial crisis on key insurance and banking value drivers.

This is reflected in daily price movements and correlations. The impact of the crisis across world insurance markets has clearly been uneven. In Figures 1 and 2 the performance of the major U.S. insurance companies is compared with that of major U.S. banks.

It is clear that the performance of insurance companies and banks tend to move together when insurance sector-specific catastrophic events are absent. Thus, the only significant deviation between insurance and banking returns before the crisis was in 2004.

This was due to hurricane losses in this year, which were covered largely by U.S. insurance companies. The (later) losses from Hurricanes Katrina, Rita and Wilma did not affect U.S. insurance companies to the same extent, as these were mainly covered by the Bermuda insurance market.

In the period between the natural disasters of 2004–2005 and the financial crisis, the performance of the

banking and insurance sectors were confined within the same narrow returns margins. However, the onset of the financial crisis in 2007 saw a significant decline in both indices and a sustained period of high volatility.

Even though banks fared rather worse during the crisis, insurance stocks also suffered huge declines in their valuations. Figure 1 shows that during the crisis period, banks sustained return swings of more than 20 per cent on certain days, while insurance company stocks’ daily returns swings were around 15 per cent.

The same picture emerges in Figures 2 and 3, which capture the performance of European and global insurers and banks, respectively.

Although the European and Global indices for both banks and insurance companies outperformed U.S. banking and insurance indices, they also suffered a sustained period when daily losses were more than 5 per cent.

For all the indices analysed in Figures 1–3, there is evidence of a marked increase in correlation between banking and insurance stocks. Tests for, and a more detailed discussion of, the correlation between these indices follow in the next section of this paper.

While the changes in valuations of banking stocks was the result of toxic assets, for insurance companies the effect was a double one as it derived from both liabilities and assets.

The liabilities in question mainly arose from credit-related business underwritten by monolines and major insurance and reinsurance companies, since this period contained relatively few insured catastrophic losses.

A direct comparison between various global insurance sectors’ returns for the period 2007–2009 shows that life insurers, global composite insurers, global reinsurers and (non-U.K.) European insurance companies were the worst performers during the financial crisis.

The sectors least affected were Asia-Pacific, U.K. insurers and U.S. property/casualty insurance companies. Figure 4 shows that all the indices bottomed out at the same time, except for U.K. insurers, which had a fairly stable performance, as shown in Figure 5.

As noted, U.K. insurers, Asia-Pacific insurers and U.S. property/casualty outperformed all the other indices. Global reinsurers no doubt fared badly as a consequence of their incursions into the financial markets and the poor quality of assets on their balance sheets.

The superior performance of U.S. property/casualty insurers is probably due to the levels of capital these insurers had managed to build up since the major catastrophes mentioned earlier.

The investment policy of property/casualty insurers, with its preference for government bonds rather than equities and private bonds, also helps to explain this phenomenon.

Their performance can also be contrasted with that of U.S. and U.K. life insurance companies, which had significant holdings in equities and corporate bonds.

Clearly, the poor performance of equity markets, and impairments in the assets in which life insurers invested heavily, weighed down on their valuations. A closer look at U.K. insurers’ performance shows a different picture from other markets, which was matched only by Asia-Pacific insurers.

It is apparent that in the United Kingdom the financial crisis did not affect the insurance sector in the same way as it affected banks.

As shown in Figure 5, the value of U.K. banks (FTBK Index) dropped nearly 78 per cent between 2004 and the peak of the financial crisis in early 2009. U.K. insurance companies (FTIC Index) during the same period outperformed banks.

Their valuations were 79 per cent above those of 2004 in 2007, but dropped by 54 per cent from this peak when AIG’s problems emerged in 2008. However, the valuations of U.K. insurance companies did not suffer the sustained declines seen in the banking sector, which only bottomed out after a second wave of government bail-outs in 2009.

The reason for the divergence between the performance of banks and insurance companies lies mainly in the quality of their assets and their degree of exposure to credit-related losses. U.K. insurance companies also fared better than the global banks (BBG World Banks Index) and insurance companies (BBG World Insurance Index).

The performance of global banks and insurance companies during the financial crisis was pretty much the same. One plausible explanation for this is the bancassurance models followed by major banks and insurance companies that make up these indices.

Another explanation is found in the high level of exposure that the major banks and insurance companies had to toxic assets and liabilities underwritten on these assets. The cross holdings between banks and insurance companies in Europe, which are not highly prevalent in the United Kingdom provide an explanation for the contrasting performance of these markets.

Again, in the United Kingdom the insurance market is not dominated by a few big companies. This is not the case in Europe, where big companies with cross-bank ownership dominate the market to a greater extent.

Their dominance weighed heavily on the indices during the crisis and, at least, calls into question the strength of the bancassurance model. We can safely conclude that size and dominance in a market are not good for the stability of an economic system.

In the banking sector, size and dominance clearly played part in the underperformance of banking stocks and subsequent damage to the worldwide economy. This is reflected in the recent proposals of the Obama Administration, which highlight size and dominance as major contributors to the global financial crisis.

Finally, we can note that while many banks breached their solvency capital requirements in the course of the crisis, most insurance companies remained within their solvency margins.

The use by banks of softer forms of capital to lever their capital structures also helps to explain their weaker financial position during the crisis. Although insurance companies under the Solvency I requirements are allowed to use softer forms of capital, the proportion allowed to them is much lower than that permitted by Basel II.

The big insurance companies that took a less conservative approach to using softer forms of capital are those that had their stock valuation weighed down most heavily, especially in Europe. This calls into question the right to use such softer forms of capital under the Solvency II regime.

Since the use of softer forms of capital to lever the capital structure played such a significant role in banking collapses, there is arguably a need to increase the proportion of pure equity used by insurance companies as risk capital, so as to limit the level of leverage allowed to them.

Location: Indonesia