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Why an insurance crisis isn’t on the cards

Author: ICAEW Insights

Published: 15 May 2023

Banks and insurers are both balance sheet businesses. But different business models and risks explain why insurers are less likely than banks to be affected by recent economic events.

Memories of the 2007/08 global financial crisis are littered with UK banking sector casualties – the Royal Bank of Scotland, Northern Rock and HBOS, to name but a few. The 1990s saw the demise of Barings Bank and the Bank of Credit and Commerce International (BCCI). In contrast, Equitable Life (2000) and possibly Independent Insurance (2001) are the only two insurance failures to prick the public’s recent consciousness.

In fact, while the Financial Services Compensation Scheme (FSCS) website suggests UK insurance failures are infrequent, there are more than the two mentioned above. Further afield, a European Insurance and Occupational Pensions Authority (EIPOA) database of failures and near misses across the EU between 1999 and 2020 – including the UK prior to Brexit – indicates that insurers also fared badly during the 2007/08 crisis. In 2008, American International Group (AIG) would also likely have entered insolvency in America were it not for US government support ($182bn by March 2009). 

What is noticeable, however, is that bank failures have periodically had a significant knock-on effect, not just across the banking sector but across the economy as a whole. This is partly due to their size – RBS had total assets of £1,126bn at the end of 2007 (excluding the purchase of ABN AMRO), whereas Equitable Life had assets of £35bn at the end of 2000).

However, the difference in underlying business models and balance sheet structures of banks versus insurers is also a factor. Put simply, banks have short-term (including on demand) liabilities funding long-term assets, whereas insurers have short- and long-term liabilities supported by short- and long-term assets.

A significant effect of the different business models is how market confidence can be affected, and with banking – unlike insurers – this can be highly contagious as witnessed recently in the US, with fears about Silicon Valley Bank (SVB) transferring to other similar banks.

Different business models

Banks have a significant maturity mismatch that does not exist with insurers. A commercial bank’s core business is to accept a mix of demand, short- and longer-term deposits, which are used to fund typically longer-term loans such as mortgages and corporate loans. 

This pools savings to facilitate larger and long-term investment while allowing access to monies on demand or at short notice if required. Banks also hold a portfolio of short-term liquid assets (eg, gilts) to cover unexpected outflows of deposits. 

Demand deposits provide customers with the ready cash for day-to-day transactional needs – wages and salaries are paid in; living expenses are paid out. Term deposits are usual for savings or surplus funds.

Insurers

An insurer can provide insurance cover (typically motor, household, health); pensions and retirement products (such as annuities, personal pensions); or wealth products (investment and savings products such as unit linked funds).

Insurers accept premiums in return for a promise (a liability) to pay an insurance claim as with motor or household insurance policies, to pay an annuity or to repay the units in a linked fund. Insurers’ assets are financial instruments (shares and bonds) and other investments (property) that will provide the income streams to enable the payment of the promise. 

Unit link funds are repayable on demand. General insurance claims arise on the occurrence of some future insurable event which could conceivably happen once premiums are paid and cover starts. Life cover such as annuities, however, can stretch many years into the future.

The assets can have short maturities but are often long-term (equities, 30-year bonds, infrastructure, equity release mortgages) to provide income streams that match the term profile of the payment obligations.

Similar asset side risks

The assets of insurers and banks can be very similar and consequently can be exposed to the same risks – for example, credit risk from default or non-payment, market risk from price moves. 

However, the mix of assets will be different and so they will not always be affected to the same degree. For example, a downturn in the UK housing or commercial real estate market will affect both, but banks are more exposed.

Both hold securities and have been adversely affected by the recent interest rate rises causing significant price falls and loss. UK insurers, and typically banks for their liquidity portfolios, carry these assets at fair value and so there are no hidden losses on the balance sheet, as with SVB.

But different liability side risks

Insurance or investment contract (for example, unit-linked) liabilities are generally an estimate of the amount that will be necessary to settle any potential uncertain future claims or redeem units. 

The estimate of a future insurance claim is affected by factors such as inflation, mortality, and morbidity that could affect the likelihood of a claim occurring, the timing of a claim or the amount of a claim. When estimating annuities, while the annual payment might be known, it still depends upon how long the policyholder will live for.

With unit-linked funds, the estimate is generally based on the market value of the underlying assets in the fund. The risk of insufficient assets to cover liabilities is therefore lower than with banks. The funds will typically have liquid assets to meet withdrawals, but where there are illiquid assets, the funds may have the ability to defer redemptions to manage the risk.

In contrast, bank deposits are not an estimate as the bank has an obligation to repay the value of the monies deposited with it. And for demand and short-term deposits, the repayment could be now or in the very near future. The maturity mismatch in a bank’s assets and liabilities means that liquidity risk is a significant issue for banks. 

A large proportion of a bank’s deposits are on demand, for which there is no notice period or other restrictions on withdrawal. This is not normally a problem as customers tend to leave their money untouched – ie, deposits act like long-term liabilities. However, this can change, especially when confidence in the bank wanes, and the bank can experience a sudden large outflow of deposits, otherwise known as a bank run, which can leave it insolvent if it has not maintained sufficient liquid assets.

It does not help that banks are part of an interbank system and an integral part of the payment system, where there can be myriad connections. Markets become worried about how risk is transferred around the banks and if the market cannot perceive where the risk is, confidence can be lost in all.

Insurers can also be subject to liquidity risk as they need to manage cash flows to pay their obligations, and unit-linked funds can be subject to immediate on-demand payments. However, they are not exposed to unexpected and potentially large payments in the way a bank is.

Read the longer version of this article: Similarities and differences between UK banks and insurers

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