January 1, 2017    5 minute read

Why French Insurers Will Be Bailed Out

Dangerous Territory    January 1, 2017    5 minute read

Why French Insurers Will Be Bailed Out

Back in 2008, banks in the US and Europe were bailed out in order to cushion the repercussions of the financial meltdown. Much has been written about this, and similarly, much money still awaits to be repaid (US bailouts and outstanding bill to be footed). Will the insurance sector, be bailed out too?

The Different Products

No insurers are born the same – the accounting principles they have to comply with are dependent on the country in which they are domiciled, and this can have big effects on how they invest. For example, in the UK, insurers have a mark to market their holdings, meaning they are exposed to the volatility of the underlying holdings.

This reduces the amount of investments that are deemed “safe” for pension funds, and as a result, UK insurers do not invest much in infrastructure, even though they arguably should. French insurers instead are not required a mark to market, meaning fixed income could plummet and (on paper), they would look just as healthy.

To illustrate the dangers to insurers, consider the French savings life insurance product, Le fonds en euros. This is a ubiquitous savings product in France: it is used to save in order to buy a car, a house, pay for education and is the bulk of savings for French people. It is so famous because returns are guaranteed, there are significant tax advantages, and it can be started with just a few hundred euros, with the ability to keep putting money aside for it.

In order to guarantee returns, the insurers providing these products need to pre-agree what that level of returns will be, and given the low-risk profile of the product, insurers are now offering a minimum guarantee of 0%, nothing like the 4% before the crisis.

The Long-Term Risks

But is this sustainable? Consider first the reinvestment risk that insurers face. Similar to pension funds, insurers have long-term liabilities to meet, for example, in the long term savings products that they sell. For regulatory reasons (as well as for liability matching motives), insurers tend to have a high allocation to government fixed income. Given their long-term investment horizon, they can buy and hold until maturity, thereby mitigating duration risk and bearing credit risk for longer. Not trading means that they have one main focus: the yield at which they buy.

The current environment of lower for longer interest rates is putting both pension funds and insurers under a lot of pressure. For one, the lower the yield of its assets, the more assets will be needed to hold to match the same level of liabilities. Secondly, with central banks currently holding 30% of government debt all around the world and with no intention to sell their positions, pension funds and insurers face increased competition and fractured liquidity on the bonds they want to buy. The more assets they need to match liabilities and the more competition they face from central banks, the lower yields go.

As the bonds that insurers hold expire, they can either buy safe bonds with negative yields or risky bonds with positive yields. This is called reinvestment risk. When buying freshly baked government bond issues at auctions, they now face negative yields as other potential buyers bid up the prices. Negative yields are not attractive when you are promising your savers a positive return, so insurers are pushed up the risk spectrum. The problem with these is the risk of default: if insurers plan to hold bonds until maturity to avoid marking to market, then they have to acknowledge that a percentage of their bonds will never mature, i.e. they will be defaulted on. So as their old bonds expire, the insurers’ business is become riskier and riskier by the day.

The Customer’s Rights Prevail

Secondly, one should consider the risk of insurers facing a bank run. French depositors have the right to ask for they money at any time, and all at the same time. The insurer is by law allowed to block withdrawals in case of a run. In France for example, they can set a withdrawal waiting period, say 3, 6, 12 months, meaning they can buy time to honour withdrawals. But calling for such period is a sign of weakness and might actually trigger the run on other insurers who are perfectly safe.

Since it only takes one insurer to trigger bank runs across the system, dangers are particularly big at a time when negative yields are already putting a lot of pressure onto their business model. Not marking to market is great during normal times, but if savers start withdrawing and insurers have to trade their positions to honour withdrawals, the mark to market blessing can turn into a curse, as people feel uncertain of how safe is their insurer.

Conclusion

Can insurers expect governments to bail them out? Yes, they can. From an investment perspective, wiping out savings is disastrous for the real estate sector, for industrials, education for the purposes of those cherished savings in Le fonds en euros meant to accomplish. But the real argument as to why governments would intervene is political: they once used taxpayer money to bail out banks, so now their reputation is at risk if they do not bail out savers. This reminds one of the helicopter money debate.

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