U.S. Insurance Industry’s YE 2015 Exposure to the Energy Sector: Warrants Continued Monitoring, But No Cause for Immediate Concern (04/26/2016)
At the close of markets on April 22, the price per barrel of West Texas Intermediate crude oil closed at $43.73. This represents a significant improvement from the environment for oil just two months ago, when the contract price traded in the area of $25/barrel, and almost dropped to $20/barrel. Nonetheless, concerns for the energy sector continue. Current prices are still substantially below where they were two years prior, and few market participants expect any substantial improvement in the near term. Bank exposures to weaker drilling companies have gained much attention. These concerns were emphasized in April when Peabody Energy, one of the nation’s largest coal producers, filed for Chapter 11 protection.Chart 1: Current Contract Price for West Texas Intermediate (6 months)
Reflecting the shifting fortunes of oil prices (as shown in Chart 1), stock prices for energy companies have been equally volatile, falling almost 37% from April 2015 to late January 2016. They have since recovered almost 30%. The U.S. insurance industry’s total common stock exposure to the energy sector was $18.3 billion as of year-end 2015, with the bulk ($15.5 billion) in P/C portfolios. The industry also had about $167.5 billion (81.3%) of aggregate bond exposure to the energy sector with life companies at year-end 2015, followed by $28.9 billion (14.0%) in bonds with P/C companies.
The U.S. insurance industry’s exposure to the energy sector is not insignificant, but it does not warrant major concern at this time. The bulk of the industry’s energy bond exposure (90%) was investment grade, with another 8% in the double-B rating category. A total of $206 billion in energy sector bonds (year-end 2015) was modestly lower than the previously reported $226 billion at the end of 2013, as indicated in a Capital Markets Bureau Special Report published Feb. 27, 2015, titled, “The Current Oil Shock: Modest Impact on Insurance Industry Investment Portfolios.” Roughly 66% of the year-end 2015 exposure was in bonds with maturities of 10 years or less (see Table 1). Exposure to countries whose economies are impacted by volatility in oil prices (i.e., oil-producing countries) has also declined from $169 billion in 2013 to $167 billion in 2014 and $152.4 billion in 2015. In addition, excluding Canada (which had the largest exposure at $33 billion), the largest year-end 2015 investment in an oil-producing country was Mexico at $14.3 billion.
Table 1: NAIC Designations for Energy Sector Bonds by Maturity
NAIC Desig < 1 yr 1 - 5 yrs 6 - 10 yrs 11 - 20 yrs >20 yrs Total 1 4,326 22,092 18,985 9,692 12,787 67,883 2 9,165 31,282 32,918 14,063 29,923 117,351 3 945 6,552 5,132 1,801 1,677 16,107 4 77 1,983 1,503 53 37 3,653 5 125 460 392 - 47 1,024 6 2 49 7 - 5 63 Total 14,640 62,418 58,937 25,609 44,476 206,080 NAIC Desig < 1 yr 1 - 5 yrs 6 - 10 yrs 11 - 20 yrs >20 yrs Total 1 2.1% 10.7% 9.2% 4.7% 6.2% 32.9% 2 4.4% 15.2% 16.0% 6.8% 14.5% 56.9% 3 0.5% 3.2% 2.5% 0.9% 0.8% 7.8% 4 0.0% 1.0% 0.7% 0.0% 0.0% 1.8% 5 0.1% 0.2% 0.2% 0.0% 0.0% 0.5% 6 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Total 7.1% 30.3% 28.6% 12.4% 21.6% 100.0%
As shown in Table 1, with almost 10% of the U.S. insurance industry’s bond exposure to the energy sector below investment grade, and more than 20% with maturities of more than 20 years, market values will potentially be volatile and warrant continued attention by state insurance regulators. Focusing specifically on below investment grade bonds, the total par value for the industry was $22.8 billion, with a book/ adjusted carrying value (BACV) of $20.8 billion and a reported fair value of $17.2 billion at year-end 2015.
The Capital Markets Bureau will continue to monitor market trends in the energy (and related) sector and report as deemed appropriate.
- Year-End 2015 U.S. Insurer Exposure to Private Equity Funds Decreases;
Hedge Funds Increases (04/04/2016)
On March 4, 2016, the NAIC Capital Markets Bureau published a special report on the U.S. insurance industry's exposure to private equity funds and hedge funds, which included data as of year-end 2014. The 2015 annual financial statements have now been submitted; while there are likely to be some continuing updates, significant changes are unlikely. This Hot Spot provides information on exposures for year-end 2015 and highlights changes since the prior year.
As of year-end 2015, the U.S. insurance industry held approximately $65.5 billion in private equity funds, a decrease of $4 billion since year-end 2014. Over the same period, hedge fund exposure increased to $17.7 billion from $16.8 billion. To gain further insight into these exposures, the Capital Markets Bureau sorted the private equity funds and hedge funds investments held in 2015 by company size (that is, assets under management, in seven groupings), as shown in Table 1 below.Table 1:
2015 Year-End Exposure Insurer Groups Based on Asset Size Private Equity Funds Hedge Funds < $250mm 177,479,907 194,360,215 Between $250mm and $500mm 360,807,226 422,921,764 Between $500mm and $1B 512,961,671 516,060,586 Between $1B and $2.5B 1,636,483,959 2,721,927,595 Between $2.5B and $5B 1,509,320,496 1,516,232,142 Between $5B and $10B 2,962,036,080 1,306,677,724 Greater than $10B 58,309,779,312 10,978,103,364 Grand Total 65,468,868,651 17,656,283,390 Change from 2014 (4,034,045,170) 865,133,360 -5.8% 5.2%
Notably, larger insurers (i.e., those with greater than $5 billion asset under management) generally reduced their exposure to both private equity funds and hedge funds during the year. (See Table 2.) Smaller and mid-tier insurer exposures to private equity funds stayed roughly the same. However, smaller and mid-tier insurers increased their exposures to hedge funds, more than offsetting the decrease within the larger insurers. Among the group of smaller insurers (i.e., less than $500 million assets under management), 31 of the 86 companies are new investors in hedge funds. Among the midtier group of insurers (i.e., between $500 million and $5 billion assets under management), 32 of 135 were insurance companies that reported exposure in 2015, but did not report exposure in 2014.Table 2:
Percent Change Private Equity Funds Hedge Funds Smaller Insurers -0.5% 9.7% Mid-Tier Insurers 0.0% 33.7% Larger Insurers -6.2% -3.1%
As shown in Table 3, in 2015, 89.1% of the industry's exposure to private equity funds was with the largest insurance companies—that is, those with $10 billion or more assets under management. Similarly, 62.2% of hedge fund exposure is also within the largest insurers category. There were a total of 343 U.S. insurance companies with at least some exposure to private equity funds, and 331 with some exposure to hedge funds.Table 3:
Percent of Total PE or Hedge Funds Private Equity Funds Hedge Funds < $250mm 0.3% 1.1% Between $250mm and $500mm 0.6% 2.4% Between $500mm and $1B 0.8% 2.9% Between $1B and $2.5B 2.5% 15.4% Between $2.5B and $5B 2.3% 8.6% Between $5B and $10B 4.5% 7.4% Greater than $10B 89.1% 62.2%
For both private equity and hedge funds, the exposure among U.S. insurers as a percent of total invested assets continues to be relatively modest and was 1.2% of total invested assets as of year-end 2015. Table 4 shows U.S. insurer exposure to private equity and hedge funds as a percentage of total invested assets in 2015.Table 4:
Percent of Invested Assets Private Equity Funds Hedge Funds < $250mm 0.1% 0.2% Between $250mm and $500mm 0.1% 0.1% Between $500mm and $1B 0.2% 0.2% Between $1B and $2.5B 1.4% 2.3% Between $2.5B and $5B 1.1% 1.1% Between $5B and $10B 0.9% 0.4% Greater than $10B 1.4% 0.3% Total 1.2% 0.3%
As noted in the March 2016 special report, performance (in terms of returns) for private equity funds and hedge funds have, in past years, proven to be less attractive relative to more traditional investments, and they remain relatively volatile. There are also concerns about transparency and liquidity. Additional review, especially for smaller and mid-tier insurers, focusing on exposure for individual companies as a percent of capital and surplus, is warranted.
- Negative Interest Rates and Market Implications (02/16/2016)
Recent weeks have seen considerable discussion about negative yields and negative interest rates, not the least of which were comments made by Federal Reserve Chair Janet Yellen. Negative interest rates—or in effect, paying a financial institution to store cash—seems counterintuitive. But, major central banks are using this unconventional tool in their efforts to stimulate economic growth. The expectation is that they will encourage banks to increase lending activity, resulting in more consumer and business spending. In addition, negative interest rates could lead to the devaluation of a country’s currency, making exports more competitive.
In June 2014, the European Central Bank (ECB) cut the deposit rate, or the rate banks receive for funds deposited at the central bank, to negative and lowered it further twice since then. The central banks of other countries—including Japan (most recently in January 2016), Sweden and Switzerland—have also adopted a negative interest rate strategy. On Feb. 10, 2016, in a testimony before the Committee on Financial Services, Yellen was questioned on the possibility of negative interest rates in the U.S., and she commented that the concept is not “off the table” but that further analysis is required to determine its feasibility—legally and structurally. Nevertheless, she said there are no expectations “that the FOMC (Federal Open Market Committee) is going to be soon in the situation where it is necessary to cut rates” given the strengthening labor market and continued moderate expansion in economic activity. However, the market appears to disagree—with the 10-year Treasury yield down 52 basis points (bps) since the beginning of the year to 1.75% as of Feb. 12, 2016—so it will be interesting to see if weakness in either, or both, of these indicators changes Yellen’s view.
Chart 1: Central Bank Policy Interest Rates
As central bank rates serve as a benchmark for borrowing costs, some sovereign bond yields have turned negative—particularly at the shorter end of the yield curve, and in some cases, as far out as six years and even beyond (e.g., Germany, Japan, the Netherlands and Switzerland). Negative yields on market instruments are different from negative rates at central banks. As interest rates have fallen near zero, prices of bonds have traded above par, resulting in their yields becoming negative. In addition, as central banks continue asset purchase programs to stimulate the economy, the additional demand has resulted in even higher bond prices and greater negative yields.
Chart 2: Government Bond Yield Curves
The impact of negative interest rates on the capital markets is akin to an extreme case of low interest rates. Negative yields on government securities lead to even lower yields on investments, putting further pressure on net interest margins and profitability of banks. They could pass through the added costs to their customers, but it would be at the risk of customers withdrawing deposits or losing customers altogether. Since U.S. insurance companies, for the most part, invest in assets that are priced to earn an expected return above a benchmark government rate, a negative yield on the relevant U.S. Treasury rate would result in a lower expected return unless the market-based premium expanded to offset that negative impact. In addition, insurance companies would likely find it challenging to meet long-term liabilities in a negative yield environment—particularly life insurance companies that offer products with fixed rates. Although there has been limited evidence of insurance companies reaching for yield in the past several years, a sustained period of negative yields (after what has already been a lengthy period of low interest rates) could create significant challenges that might encourage them to take on added, and potentially excessive, risks and invest in higher yielding assets at an increasing rate. Negative yields would also significantly affect the money market funds space—a $3.1 trillion market as of Dec. 31, 2015, according to U.S. Securities and Exchange Commission (SEC) data. Money market funds typically invest in highly-rated short-term corporate or government debt for a small return. If these returns turn negative, the business model of money market funds would no longer make sense, and the liquidity and capital preservation they provide would no longer be available to investors.
Although negative yields in the U.S. seems unlikely, the Capital Markets Bureau will continue to monitor developments and trends in the U.S. and global economies and report as deemed appropriate.
- Complications for U.S. Insurers Caused by Flatter Yield Curve (02/10/2016)
Market volatility that began at the end of 2015 and increased significantly in the first few weeks of 2016 has led to a number of concerns for investors. More specific to the U.S. insurance industry is the retracing of long-term rates to lower levels, resulting in a flattening of the U.S. Treasury yield curve. In a testimony on Feb. 10, 2016, Federal Reserve Chair Janet Yellen combined a “steady-as-she-goes” account of Fed policy with an acknowledgement of intensifying risks. Virtual zero yields for ten-year government bonds in Japan and Germany that have, on occasion, drifted into negative territory are certain to weigh further on U.S. interest rates.
U.S. Treasury Yields (30-Year, 10-Year and 12-month)
As of February 10th, the differential between the 30-year and 12-month U.S. Treasury yields narrowed to 202 basis points, its thinnest margin in the last five years. Financial institutions in general tend to achieve higher margins with higher interest rates as they typically improve the margin earned on their investment portfolios versus their costs, including payouts to investors, depositors and policyholders. Insurance companies usually benefit from steeper yield curves given their longer-dated liabilities.
Differential between 30-year and 12-month Treasury Yield
Meanwhile credit spreads—as measured generically between investment grade and below-investment grade markets—have shown similar volatility over the last six months. Current levels for investment grade and below-investment grade indices are at the highest levels since the end of 2012.
Benchmark Credit Spreads for Investment Grade and Below‑Investment Grade
Notable is the differential between investment grade and below-investment grade spreads: at 451 basis points, it is the widest margin since the end of 2012. While credit concerns may be applicable to all corporate credits, the wider differential reflects a higher level of concern for weaker, more speculative credits. One driver of wider below-investment grade spreads is the weaker companies in the oil and gas sector. Oil prices, as measured by the West Texas Intermediate benchmark, have dropped more than 70% from their peak in 2011 and more than 50% from their more recent high in 2015. Exposure to below-investment grade investments by U.S. insurers increased slightly in 2014, and while 2015 annual statements have not yet been submitted, below-investment grade exposure is expected to have increased (modestly) again in 2015. Overall, we expect exposure remains modest relative to overall assets and historic peaks.
Differential Between Generic Investment Grade and Below-Investment Grade Spreads
Lower interest rates, particularly long-term interest rates, and a flatter yield curve have presented an investment challenge for U.S. insurers, narrowing the net margin between net portfolio yields and crediting rates. This dynamic moderated somewhat in late 2013 through early 2015, but has returned in recent months. With wider credit spreads on below-investment grade bonds, investors in general are at least getting paid more for taking on the additional risk. However, given the level of volatility in the economy, questions remain as to whether or not it is enough. Reflecting on the increased level of market value volatility, the vast majority of bond investments for U.S. insurers are held at amortized cost. The notable exception is for below-investment grade investments held by companies that do not maintain an Asset Valuation Reserve. This includes mainly property/ casualty companies that increased their exposure to below-investment grade debt from roughly 2% in 2010 to more than 4% based on the most recent reported data.
While U.S. insurers have managed reasonably well through the lower level of interest rates and flatter yield curves in the last five years, albeit with tighter margins and weaker earnings. The renewed market dynamic, along with an increased level of market volatility that will likely cause alternative investments to become less attractive, warrants further regulatory vigilance. The Capital Markets Bureau will continue to monitor these trends and report as deemed appropriate.