The Fragility of the Life Insurance Industry During the COVID-19 Crisis
The stock prices of life insurance companies declined sharply during the onset of the COVID-19 crisis. To illustrate this, the figure reports the drawdown, defined as the percent decline from the maximum to the minimum of the cumulative return index, from January 2 to April 2, 2020. The drawdown of a portfolio of variable annuity insurers is -51% during this period. This is a substantially larger drawdown than the S&P500 (-34%), the financial sector more broadly (-43%), and rivals the airline industry (-62%). Some of the most affected companies experienced a drawdown of -65% or more (e.g., AIG, Brighthouse, and Lincoln). While this apparent fragility may be concerning in general, the solvency of life insurance companies that safeguard a large share of long-term savings and insure health/mortality risks is particularly important during a pandemic.
It may be tempting to conclude that life insurers experienced large losses due to the high death toll of the coronavirus, but this is not necessarily the case, as annuities represent a large fraction of insurers’ liabilities and insurers and, in fact, profit from those contracts if the policyholders die unexpectedly early. Instead, the fragility is the result of various insurance products with that come with minimum return guarantees. The traditional role of life insurers is to insure idiosyncratic risk through products like life annuities, life insurance, and health insurance. With the secular decline of defined benefit pension plans and Social Security around the world, life insurers are increasingly taking on the role of insuring market risk through minimum return guarantees. In the US, life insurers sell retail financial products called variable annuities that package mutual funds with minimum return guarantees over long horizons. Variable annuities have become the largest category of life insurer liabilities, larger than traditional annuities and life insurance.
From the insurers’ perspective, minimum return guarantees are difficult to price and hedge because traded options have shorter maturity. Imperfect hedging leads to risk mismatch that stresses risk-based capital when the valuation of existing liabilities increases with a falling stock market, falling interest rates, or rising volatility.
The fragility is not new to the current crisis. During the 2008 financial crisis, many insurers including Aegon, Allianz, AXA, Delaware Life, John Hancock, and Voya suffered large increases in variable annuity liabilities ranging from 27% to 125% of total equity. Hartford was bailed out by the Troubled Asset Relief Program in June 2009 because of significant losses on their variable annuity business. Risk mismatch between general account assets and minimum return guarantees leads to negative duration and negative convexity for the overall balance sheet and poses a challenge for life insurers in the low interest rate environment after the financial crisis. As a consequence, the stock returns of US life insurers have significant negative exposure to long-term bond returns after the financial crisis.
The persistent low-rate environment in combination with declining interest rates, widening credit spreads, and increased volatility will be a challenge to the balance sheet of life insurers in the foreseeable future.