How Do Volatile Markets Affect Insurance Companies?

Joe Sutton -- Aug 11, 2011

This week we have all watched out 401k's turn into 301k's. I think it is a good time for a discussion of how the current state of the market effects insurance companies. The first question that I have heard recently is- "Does the downgrade of U. S. sovereign debt effect insurance companies?  The short answer is, not directly. I will stop here on this topic, but if you would like to have a discussion of the valuation of debt instruments to be held to maturity, email me.

As an interesting aside, insurance companies own roughly $260 billion of U.S. debt.

The more important question is, Do the large downward moves in the markets affect insurance companies? and the answer is, You bet they do.

To greatly oversimplify how insurance companies work, they can be seen as two big piles of investments:

  1. Reserves - this is "money" held to pay future claims. When you pay your premium, some portion of it is but aside to cover the likelihood that a claim will arise in the future, or to pay the future portion of existing claims. The important thing to understand about this process is that no matter how sophisticated the insurance company is, the amount they put aside is a guess at some level. As a matter of fact, every quarter reserves are adjusted either up or down. These fluctuations can be significant. For example, the below is from last week.

    The Hartford’s asbestos costs were considerable and included a prior year reserve increase of $206 million. The company said the increase was primarily driven by higher frequency and severity of mesothelioma claims, particularly against certain smaller insureds. Other insurers are also still dealing with asbestos issues.
  2. Surplus -  given the nature of reserves, insurance companies need to have a cushion available. this cushion is referred to as surplus, and it is this "surplus" that can be greatly effected. Reserves are traditionally invested in treasury bonds or other low risk vehicles, that pay out a very small amount of interest, but are safe and liquid.  Surplus on the other hand can be invested in a variety of ways, including stocks, commercial real estate and even other more complex vehicles. A great deal of the profit that insurance companies report is actually related to surplus investments

To illustrate this point-  In the first quarter of 2011 Travelers Insurance company,had total net income (profit) of $839 million. Of that $779 was income from their investments. And is that looks bad, realize that Travelers is among the best. In 2010 the total insurance industry had a combined ratio of 102.6%. This means that the industry claims and expenses were 102.6% of the premium dollars that were taken in.

So, if you have spent the time to read my lecture on insurance company finances, you can see that a change in the market can lead to two things:

  1. Much lower profits (or even loses) due to decreased investment income
  2. Shrinking surplus ,or cushion, due to a reduction in investment portfolios.

When we spend a great deal of time talking about how solid Great American is, it is because of the above. When times get rough, you need a carrier with the strength and financial flexibility to weather any storm. We have become very weary of lower rated, less capitalized insurers over the last week.