The recent banking crisis on both sides of the Atlantic has shone a light in asset management circles on the due diligence process undertaken by end investors on their counterparties. A significant percentage of the venture capital industry faced a potential liquidity crisis, and consequently, investors are looking more closely at counterparty risks of all types, not only at the asset manager level, but through to the underlying fund or managed account portfolio level as well.
Just like many other asset classes in the private markets, counterparty risk in the life risk investing world comes in many forms. In markets such as life settlements and life ILS, the most significant of these is the life insurance company which has issued the insurance policy.
If a life insurance company were to fail, the first losses would, in theory, be borne by the shareholders and the regulatory surplus capital. But many safeguards exist in the insurance industry at the insurance company level – more so than in the banking industry, where most of the protections are at the consumer level. So, even if there was a technical failure, the assets backing the liabilities should mostly or wholly remain, and policyholders would still be in good standing. Scott Willkomm, Chief Executive Officer at Life Equity LLC, says that, whilst the likelihood of a life insurance company default is low, an obvious first line of defence against this risk presents itself.
“Most life insurance companies are highly rated, have conservative balance sheets, and benefit from a strong regulatory infrastructure,” he said. “But diversifying counterparty risk is a natural place to start for a simple risk mitigation strategy. Limiting your exposure to a single carrier, regardless of its financial strength, is a prudent approach.”
The main driver of SVB’s troubles was its investments in longer-dated securities, which presented it with a classic asset/liability duration mismatch. Fortunately for capital markets participants in life risk, there are few similarities between bank and life insurance company balance sheets. Aside from mortality risk, which is hedged differently to assets, economic risks do exist, but rarely in isolation, as they can be within a bank.
Consequently, the likelihood of an ‘insurance company run’ is improbable. Even if a situation were to occur where every single US universal life insurance policy holder wanted to sell their policy back to the insurance company at the same time – and therefore the insurance company would need to pay out the cash surrender value – this would be a manageable process, as there is no requirement to pay out policy holders the same day and there may be all sorts of management tools to slow the process down or to apply disincentives and penalties.
Aside from mortality/longevity risks that they themselves run within their pricing, the main day-to-day insurance-related risk, at least in the life settlement market, is the Cost of Insurance risk – the risk that the insurance company increases the COI rates on certain types of policies, the consequence being that these additional costs eat into the eventual investment return. But this is an investment due diligence risk, not an operational one, and certainly with policies funded on a minimum basis, there is little direct asset market risk. Perhaps the closest equivalent of a ‘bank run’ for insurance companies would be an extreme mortality event.
“The SVB scenario equivalent for a life insurance company could be the onset of a huge pandemic or epidemic – one that would be significantly worse than the recent Covid-19 one,” said Roger Lawrence, Managing Director at consulting firm WL Consulting. “If there was a pandemic which had a much higher mortality rate, insurance companies would be on the hook for a rising rate of pay-outs, which would not only threaten solvency with worse mortality than they planned for, but a need to meet the cash flow of more claims, and every insurer will have a severity threshold at which they couldn’t access the capital to pay the death benefits they are liable for.”
Pandemic risk is, however, arguably akin to a black swan event and is something outside of the insurance company’s control, whereas the decision to invest in certain illiquid securities, or not, is something that is within a bank’s control. Indeed, the life risk investing industry has long pointed to life insurance companies being robust counterparties, not weak ones. Many have excellent credit ratings, and even tick ESG boxes given the societal benefit of insuring lives and livelihoods.
“There have been some insolvencies of some small life insurers during the last 7 or 8 years, but the last big company one was about 35 years ago, before the first introduction of risk-based capital regulatory regimes in the 1990s,” said Chris Conway, Chief Development Officer at ISC Services. “Yes, they are different types of businesses serving different purposes. But from a counterparty risk perspective, life-based investors have it pretty good.”
Bank failures do and will have some impact everywhere, especially if nations refuse to underwrite them. Insurers will suffer within their operational division, losing assets held in cash which may slow claims payments down and at the simplest level, they may not be able to access deposits to pay staff, as was the case with the recent turmoil in venture capital circles. In the life settlement space, another impact of a bank failure is that a bank can also be the securities intermediary and/or custodian. Although custodial roles played by banks should not be a long run counterparty risk, in the short term, there could me a messy hiatus where access to assets is not possible.
“Ideally, a life settlement fund should not bank with the same firm that it uses as its custodian or securities intermediary for the policies it owns. It’s again a simple case of diversifying risks – if a bank were to go under, then having different firms would at least not stop the operation of the fund even if there are delays in getting access to the policies,” said Lawrence.
The venture capital industry endured a difficult few days as the SVB debacle unfolded, but ultimately, the US government guaranteed all deposits at those banks, even those above the published $250,000 guarantee. Add to this the bail outs of many banks in many countries during the Global Financial Crisis and it’s easy to succumb to the idea that governments will now guarantee deposits ad infinitum. But you never know, and Lawrence says that for life risk investors, diversification is the name of the game.
“We might always live in hope for a free lunch, but you are wise to be prepared to buy your own,” he said. “Ensure you do as much due diligence on your operational risk as for your investment risk.”