Financial innovation and standards for the capital of life insurance companies

New England Economic Review, Jan-Feb, 1995 by Richard W. Kopcke

Since their inception, insurance companies, banks, and other financial institutions have played prominent roles in our capital markets. These intermediaries have fostered saving and investment by issuing liabilities that appeal to savers in order to purchase the obligations of investors on attractive terms. Among financial intermediaries, life insurance companies traditionally have distinguished themselves by attracting long-term savings and by providing long-term financing for investment in real estate and durable equipment by businesses.

Because financial intermediaries must bridge the often disparate interests of savers and investors, the evolution of these institutions and their products depends on the opportunities created by the needs of their customers. To a degree, financial intermediaries have been coping throughout this century with the consequences of their own success. By supplying much of the financing needed to build our modern industrial corporations and by giving capital markets a good foundation, financial intermediaries have helped create enterprises that no longer depend so greatly on intermediaries for funds. Furthermore, as the nation has become wealthier and credit markets have become deeper, savers have become more willing to assume more risk in pursuit of a greater share of the returns from their investments. These demands, coupled first with rising interest rates between the late 1960s and the early 1980s, then with the capital gains that subsequently accompanied falling rates, precipitated many of the financial innovations of the last three decades. As rising interest rates depressed their profits, the capital per dollar of assets of many intermediaries fell for a time as they attempted to offer competitive terms for savings. Some, seeking to earn higher yields or to maintain their share of savings, also made riskier investments or sold riskier liabilities. In time, many adopted a "mutual fund" approach to their business as they unbundled their services.

After profits and capital ratios subsided for financial intermediaries during the 1970s, those who supervise and regulate these enterprises adopted new methods of measuring and controlling the risks arising from financial intermediation. Regulators increasingly favored enforcing capital requirements that rise with an intermediary's holdings of certain risky assets, appraising risky assets according to their market values, and imposing prompt remedies when capital ratios become too low. These steps, of course, reinforce intermediaries' interest in redesigning their liabilities to resemble mutual funds, wherein savers implicitly provide the capital to support their investments. The returns on investments in many popular life insurance and annuity contracts, for example, depend on the performance of funds offered by life insurance companies to their policyholders.

More stringent standards for capital may reduce the risk of insolvency, but they also can impose greater costs on financial intermediaries. For intermediaries that hold assets not traded consistently in public markets, the strategy of tying capital to holdings of certain risky assets, marking these assets to market, and requiring the sale of these assets when capital appears to be deficient can entail costs that exceed the benefits. The success of this strategy for managing risk depends greatly on the nature of the risks inherent in those assets deemed risky. The conflation of risk-based capital requirements and of marking risky assets to market is a conservative policy when the values of these assets tend to follow random walks. If, on the other hand, these values tend to revert to trends over time, this policy can increase rather than diminish the risks inherent in financial intermediation. In either case, requiring intermediaries to sell risky assets into illiquid markets tends to dissipate rather than preserve their capital. Finally, the linking of capital requirements to investments in specific assets and the marking of these assets according to their disposal values take a very narrow view of the risks inherent in financial intermediaries' balance sheets, a view that can either exaggerate or diminish the magnitude of these risks. Because the risks borne by an intermediary depend on the mix of assets in which it invests and the liabilities it issues to finance these assets, prudent standards for capital should weigh the characteristics of an intermediary's entire portfolio of assets and liabilities.

This article opens by briefly discussing the role of financial intermediaries in capital markets. The next three sections describe in more detail the distinctive features of life insurance companies. This discussion first examines how insurers have reshaped their liabilities to cope with the consequences of rising interest rates and increasing competition for savings during the past three decades. It also examines how insurers have restructured their assets. This discussion then analyzes the consequences of these financial innovations for the capital of the industry as well as the distribution of capital among life companies.(1) The following section examines the issues relevant for measuring and controlling the capital of life companies, describing when some of the more common approaches are likely to work best and when their costs are likely to exceed their benefits. The final section offers the conclusions.