A Potential US Default and Insurance

Posted on Jul 21, 2011 by Sergio Ulloa (G+)

Over the past few weeks, the various worldwide credit analysis and ratings agencies have weighed into the current political gridlock taking place in Washington D.C. and are now forecasting the effect a possible U.S. default could have on the international insurance industry. The creditworthiness of the United States, which has always enjoyed a top AAA rating internationally, is now being threatened as President Obama and opposing Republican lawmakers continue to clash over how to best resolve the nation's considerable debt problem. Republicans would like any increase on the US$14.3 trillion debt ceiling to feature substantial cuts in government spending, while the Obama Administration wants to generate significant revenue through tax increases. The country at large is facing an August 2 deadline, after which the federal government will not have enough funds available to pay all of its obligations without being able to borrow more. Two days after that deadline, the Treasury has a US$90 billion bond due to mature. International insurance analysis and ratings agency A.M. Best has been at the forefront with concern over the continued inability of the U.S. government to resolve a potential debt crisis that will impact the global economy. The agency has been stress-testing US-based insurers to see how their balance sheets would fare if in fact the United States was downgraded from AAA credit rating to AA., and may consider adjusting its outlook for the entire US life and annuity sector to negative from stable. A.M. Best conducted the tests with its proprietary capital model, Best's Capital Adequacy Ratio (BCAR), and have thus far found that a U.S. sovereign downgrade would lead many insurers to reevaluate their underwriting leverage, as they would not be able to maintain their operations at historical levels without negatively impacting their long term financial strength. The company released a statement on the findings this week that explained why insurance companies in particular are vulnerable to the effects of potential credit downgrade. "As large-scale investors in U.S. Treasuries and government-backed instruments, insurers would experience a larger impact from a decline in the credit quality of the U.S. government than many other industries because of the asset leverage insurers hold," A.M. Best noted, adding that too much time had now passed on US debt ceiling negotiations to not consider the gravest of consequences. "Therefore, even though A.M. Best expects a compromise to be worked out to raise the debt ceiling, the probability of a U.S. sovereign downgrade is no longer negligible, and the risk inherent in virtually all investments has increased," the credit agency reported. Data from the reports indicate that life insurance companies' risk-adjusted capital positions in particular would be vulnerable to the effects of credit downgrade as they performed less admirably under extreme stress scenarios. A.M. Best explained that continued economic uncertainty will constrain most US life insurers' ability to maintain their revenues and earnings. "The life insurance industry is clearly more adversely impacted than the property/casualty (P/C) industry because of its exposure to investment risk through higher asset leverage. In addition to the larger impact to the life industry in this stress test, there are other significant issues the life industry would face (disintermediation, liquidity, etc.)." Life insurance companies, who always need to safeguard their assets to pay off long-term liabilities, have been major holders of debt for governments around the world. The current economic uncertainty surrounding not only the US but failing European Union members Greece, Portugal and Ireland have left life insurance companies exposed. A.M. Best notes that the current circumstances reflect our interconnected global economy and thus problems become more pervasive and require innovative solutions. "Typically, during economic crises, a global flight to quality would cause portfolios to shift away from emerging market assets toward high credit quality assets in the developed world - traditionally to the "guaranteed safety" of sovereign debt," A.M. Best stated. A.M. Best has not been the only ratings agency to recently warn insurers over the threat of a sovereign default. Standard & Poor's warned last week that a whole range of the US' most important financial companies, including insurers, could be downgraded if a deal is not struck to raise the debt limit. Moody's Investor Services came out on Wednesday and said that if the US government defaults on its loan obligations it would result in a ratings downgrade for the four US-based AAA rated insurers. Moody's identified the four American insurers as New York Life Insurance Company, Northwestern Mutual Life Insurance Company, Teachers Insurance & Annuity Association of America, and United Services Automobile Association. "Moody's believes that the linkages between an insurer's credit profile and that of the sovereign should limit the insurer's financial strength rating to one or two notches above the sovereign bond rating½The AAA-rated US insurers are currently not on review because the rating agency regards them as resilient to a one-notch downgrade of the sovereign rating. However, should the sovereign rating be lowered by more than one notch, these insurers' ratings could be lowered as a consequence," Moody's said in a statement. The criticisms leveled at national governments by these ratings agencies are certainly interesting when you consider the events following the 2008 global financial crisis. The same demands for greater fiscal responsibility and transparency were being levied at the ratings agencies by these same governments who now may need the same oversight reforms. Whoever is calling the shots at the time, the international insurance industry will only benefit from greater financial stability across as many markets as possible. Ratings Companies Mentioned A.M. Best A.M. Best Company was founded in 1899 and is a full-service credit rating organization dedicated to servicing the financial services industries, including the banking and insurance sectors. Moody's Moody's Investor Services provides credit ratings, research, credit risk management, and other services for more than a hundred thousand commercial and government entities around the world. Standard & Poor's Standard & Poor's (commonly referred to as S&P) is a business branch of publishing house McGraw-Hill. Operating out of 20 countries, S&P provides the investment community with independent credit ratings on important financial vehicles such as stocks, municipal bonds, corporate bonds and mutual funds. In addition to its risk management, investment research and credit rating services, Standard & Poor's is known for its indexes, in particular the S&P 500 index.