When bank or insurance company failures come to mind, it is probably fair to say bank failures by frequency, number and size have left more of an impression than insurance failures. In the 2007/08 global financial crisis there was the Royal Bank of Scotland, HBOS (doyens of British banking) and Northern Rock to name but a few in the UK, while further afield there was Lehman Brothers in the US; in the 90s there was Barings Bank and the Bank of Credit and Commerce International (BCCI); and the 70s saw the secondary banking crises. Equitable Life (2000) and possibly Independent Insurance (2001) are the only two insurance failures to perhaps prick the public’s recent consciousness.

Dig a little deeper, and while the Financial Services Compensation Scheme (FSCS) website suggests UK insurance failures are infrequent, there are more than the two mentioned above. Looking further afield, an EIPOA data base of failure 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. There have also been big failures such as American International Group (AIG) in the US in 2008, which would likely have entered insolvency without US government support ($182bn by March 2009).

What is noticeable however is that periodically bank failures become a sector wide issue with significant effects on the real economy, and that individually they are typically larger (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).

Banks

Leaving aside the compensation available from the FSCS, a bank failure can lead to people or businesses losing their money in the form of deposits, with an immediate knock-on impact on their spending and investment. Even if money is not lost, it may be tied up in the administrative process to resolve or wind up the bank, again affecting immediate spending.

A failed or failing bank can have a systemic effect as confidence and trust can be lost in the entire banking sector. There may then be a flight to quality with perceived weaker banks suffering deposit withdrawals. As the sector comes under stress, it can reduce lending - a credit crunch - which can put an economy into recession, increasing credit risk and losses for the remaining participants – a vicious spiral can develop.

A bank failure can be rapid, as seen recently with Silicon Valley Bank (SVB), when deposits and other funding were rapidly withdrawn leaving it potentially insolvent. In 2008, RBS and HBOS failed within 10 months of their 2007 financial statements which highlighted no concerns with their going concern status.

Insurers

A failed insurer can also have a severe effect. A policyholder may lose the premium paid and may not be able to replace the insurance cover with another provider. A more significant and immediate loss would be where there is a claim in progress that does not get paid. An individual could lose their accumulated savings in any investment or pension products. Rebuilding savings may have an immediate effect if current consumption is forgone (not to mention the stress it can cause). Some effects are longer-term – for example non-payment of annuities could significantly reduce an individual’s future income.

Insurers do not however tend to suffer from a loss of confidence in the sector in the same way as banks. Nor do insurers tend to rapidly fail in the way banks can. Those that get into difficulties generally stop writing new business and enter into run-off: a long slow death.

Financial Services Compensation Scheme (FSCS)

The role of the FSCS is to mitigate the effects of loss for a bank or insurers’ customers. It compensates bank deposits up to £85,000 per eligible individual per bank and aims to pay out within 7 days of a failure to minimise the impact on the individual’s current circumstances. With insurers, it may be able to pay the premium for a new policy with a different provider, refund any remaining portion of the premium, or pay out a valid claim in whole or part.

Refer to the FSCS’ website for the exact terms and conditions of the compensation payments they can make.

The reasons for failure can be similar for banks and insurers: at the heart of most problems are poor governance, risk management and controls. Equitable Life did not adequately reserve for its promises to policy holders; AIG did not understand the business it was writing and was overly exposed to a downturn in the US property market. HBOS did not have adequate resources for the credit and liquidity risks it took on.

Both types of business can also be affected by external events or idiosyncratic issues: a single catastrophic event (eg earthquake, tsunami) may be beyond what an insurer would reasonably provide for; Barings was affected by a ‘rogue trader’ that entered into ever larger trades that resulted in losses that the bank could not cover.

But what can clearly set the banks apart is confidence, or rather a loss of confidence leading to an exodus of depositors and other funding providers, and that the effect can be systemic. The typical cause is rising credit risk as it raises the spectre that a lender’s assets may not be sufficient to repay its liabilities. So, we see in the US that a weakness has been revealed by SVB (eg uninsured deposits, unrealised losses and weak regulatory requirements) and the market is now rooting out those banks with a potentially similar high risk profile.

A loss of confidence can also be contagious spreading from bank to bank, sometimes for no real reason other than they are banks. Deutsche Bank has had its problems, but despite its recent spike in CDS spreads, it is not clear it has the same current problems as Credit Suisse.

In addition, as revealed by events around SVB, technology in the form of media channels (including social media such as Twitter and WhatsApp) and internet banking are enabling information to be spread and be acted upon more quickly than in the past. Confidence may now evaporate much quicker.

It does not help that banks are part of an interbank system and are integral parts of payment systems, where there can be a myriad of connections. Markets become worried how risk is transferred around the financial system and where it has landed. If the market cannot perceive where the risk is, confidence can be lost in all.

Insurers can also be connected and with the banking system. Insurers and banks can invest in each other’s equity or issued bonds, and both use derivatives to manage risk. Insurers also often offload part of their insurance risk to a reinsurer, which may in turn offload part to another reinsurer - which too can make it unclear where the risks lie.

The market can lose confidence in insurers where there is exposure to common factors. For example, rising interest rates have resulted in many insurers taking losses on their bond portfolios; an increase in people’s lifespans would increase the annuity obligations of life companies. Insurers’ business models mean they are however not exposed to the rapid loss of confidence or contagion effects that can blight the banking sector.

The differences between banks and insurers stems from the differing business models and balance sheet structures. In simplistic terms, banks have short-term (including on demand) liabilities funding longer term assets, whereas insurers have short and long-term liabilities supported by short and long-term assets. Banks have a significant maturity mismatch that does not exist with insurers.

Banks

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 traditional maturity transformation is a necessary service to society as it pools peoples and businesses’ savings to facilitate larger and long-term investment while allowing them to access their monies on demand or at short notice if required. There is obviously a liquidity risk to do this, and is why banks also hold a pool 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 and pay a higher rate of interest.

Insurers

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

General insurers might be more focused on the first, life insurers on the second and third, while large insurance groups such as Aviva might offer all three.

Insurers accept premiums in return for an obligation or promise to pay an insurance claim as with motor or household insurance policies or to pay an annuity; or investments in unit linked funds. Insurers assets are financial instruments (shares and bonds) and other investments (property) that will provide the income streams to pay claims or redeem the fund units.

Unit link funds are repayable on demand. General insurance claims arise on the occurrence of some future insurable event which could conceivably happen the day the premium is paid, and cover starts. It is more likely however sometime within the year (for annual policies). 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 matches the term profile of the payment obligations.

Similar asset side risks

The assets of an insurer or a bank can be very similar and thus they are often exposed to the same risks – eg credit risk from default or non-payment, market risk from price moves. Both hold securities and have been adversely affected by the recent interest rate rises causing significant price falls and loss.

The mix of assets will however 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, like SVB.

But different liability side risks

Insurance liabilities are a payment to a policyholder that is based on some future uncertain event occurring. That might be claims for losses due to storm damage, or annuity payments over the life of an individual. Insurance liabilities might thus be said to be illiquid – unlike bank demand deposits which are liquid.

At any point in time, insurers estimate what these future payments might be. The estimate is based on those factors that affect the likelihood of a claim occurring, the timing of a claim and the amount of a claim.

The estimate determines the premium set and how much insurers need to reserve – the assets to set aside to cover future payments. The risk is that the final cost differs to the estimate because the actual factors turn out to be different to the expected factors used in the estimate, and so insurers have under-priced the risk and do not have sufficient assets. For example, higher than expected inflation will increase the future cost of repairing storm damage; people living longer than expected increases the cost of an annuity pay-out.

Sometimes future events defy predictions and modelling based on historical events. So business interruption claims due to Covid, losses due to war in the Ukraine, or exceptionally severe natural disasters have led to losses for insurers.

Unit linked fund liabilities are also an estimate, but one that is based on the market value of the underlying assets in the fund, as these will determine the value of the fund unit. The funds will typically hold liquid assets to meet withdrawals, but where there are illiquid assets, the funds may have the ability to defer redemptions to manage the risk.

Bank deposits on the other hand are not uncertain: a bank has an obligation to repay the value of the monies deposited with it. And for demand and short terms deposits, the repayment could be now or in the very near future.

Maturity mismatch of asset and liabilities

The maturity mismatch in banks’ assets and liabilities means that liquidity risk is a significant issue for banks. The contractual maturity of a large proportion of a bank’s deposits are on demand, for which a customer has no notice period and there are no other restrictions on withdrawal.

This is normally not a problem as behaviourally customer deposits act like long term liabilities: they are sticky and a bank can rely upon them remaining. This can change, notably when confidence drains from the bank. The bank can experience a sudden large outflow of deposits (a bank run) which can leave it insolvent if it has not maintained sufficient liquid assets to meet all the withdrawal demands.

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, but they are not exposed to the mismatch that a bank is and the need for sudden (and potentially large) unexpected payments in the way a bank is.

UK banks carry their liabilities (deposits) and the majority of their loan assets at amortised cost. The accounting allows this treatment for assets on the assumption that it will be held to maturity for the purpose of collecting cash flows (ie interest and principal repayment). Simply, amortised cost reflects the historical cost adjusted over time for any expected credit losses. It does not reflect the current market or fair value of an asset. So, if a bank must realise a loan to repay a deposit, and if fair value is less than its carrying value the bank realises a loss and takes a sudden capital hit.

This risk is not new and should be well understood – it is the reason banks hold portfolios of liquid assets and undertake stress tests to gauge the risk of unexpected withdrawals. In the UK the majority of bonds are carried at fair value (or the risk is hedged) – in other words, if the fair value of an asset has declined, the bank has already taken the loss and capital hit, and presumably action to rebuild its solvency position if required. It is not expected that the UK would see a scenario similar to SVB where significant withdrawals had to be covered by asset sales at a significant loss, leading to a sudden large hit to capital.

UK Insurers on the other hand typically measure all assets for accounting purposes at fair value and their liabilities at fair value or an estimate of the cost of pay-out. So as central banks have raised rates insurers’ assets have been revalued down on an ongoing basis, and there is no unrealised loss hidden within the asset side of the balance sheet to worry about. But insurers have also seen falls in the value of their liabilities: rising rates meant a higher discount rate which reduced the value of estimated insurance liabilities (by a fifth over the course of 2022 in the case of Aviva); while asset falls feed through to reduced unit linked fund valuations. This lessened the overall impact on insurers from rising rates.

There are commonalities between banks and insurers, but also some very big differences in the business models and the risks faced. Insurers can be affected by the issues currently affecting the banking market, but there is no certainty that there will be spill over or that the effect would be as significant.