Could Warren Buffett’s Berkshire Hathaway Inc. threaten the stability of the financial system? The U.S.’s top regulators are asking themselves this question as they consider whether Berkshire and other large insurers should come under Federal Reserve oversight.
The answer is yes. Regulators have already deemed American Insurance Group Inc., Prudential Financial Inc. and the insurance unit of General Electric Co. systemically important. On July 31, they will likely add MetLife Inc., the largest U.S. life insurer, to the same category, Bloomberg News reports.
The additional oversight is needed. True, insurance isn’t as risky as banking because the business doesn’t borrow short and lend long, resulting in the maturity mismatches that plague banks. Yet a sick insurer could infect the system. Federal regulators, empowered by the 2010 Dodd-Frank Act, ought to heed the lessons of the 2008 crisis.
The insurers’ role in the meltdown wasn’t confined to the near-failure of AIG and its rogue unit trading credit-default swaps. Life insurers held about $470 billion in mortgage-backed securities, about a fourth of the market. That demand, fed by state-level capital rules that treated mortgages as safe, helped produce the housing bubble. When it became clear the bubble would burst, fire sales of mortgage securities by insurers meant that other institutions, including Lehman Brothers Holdings Inc., couldn’t offload their mortgage assets. The rest is history.
It could happen again. Insurers tend to hold similar investment portfolios, making them vulnerable to contagion. Size is another risk factor: Under Dodd-Frank, a company must have at least $50 billion in assets to be considered systemically significant. The criteria also include amount of debt, extent of derivatives liabilities and level of interconnectedness to other institutions.
In this light, deeming Berkshire Hathaway systemically important wouldn’t be a stretch. With $485 billion in assets, it’s certainly big enough. At the end of 2013, it had $31 billion in credit-default swaps linked to its debt, just above regulators’ $30 billion threshold. And it had $5.8 billion in derivative liabilities, exceeding a $3.5 billion cutoff. Berkshire and other reinsurers, moreover, are highly interconnected. In 2009, five companies provided 60 percent of the world’s reinsurance — often by laying off risks with each other.
Insurers argue that defaulting on their obligations is highly unlikely. After all, state regulators make sure they are collecting adequate premiums and holding sufficient reserves. But regulators need to look at worst-case scenarios, which they failed to do last time. A default by one large insurer would put severe stress on so-called state guaranty funds (which aren’t really funds at all, but promises by insurers to bail one another out, a huge risk in itself).
Also, most insurers are undercapitalized. MetLife, for example, had tangible common equity, the best measure of financial strength, of just 5.6 percent at the end of 2013. It would be insolvent if its assets lost just 5.6 percent of their value. Prudential’s ratio was even lower at 4.2 percent. Berkshire is a notable exception with a comfortable cushion of 37 percent.
None of this argues for regulators to treat insurers like banks. Insurers don’t benefit from a taxpayer-backed safety net, as banks do. Life insurers’ separate accounts — which hold the premiums and investment returns of insured individuals — shouldn’t be treated like bank deposits, because they can’t be withdrawn on demand.
Still, the insurers protest too much. They complain that additional capital could lower their return on equity, making their shares less attractive — though they’d also be safer. And they don’t want federal regulators asking such awkward questions as “Could you absorb losses like those of 2008?” It’s a shame regulators weren’t asking awkward questions in 2007.
–Editors: Paula Dwyer, Clive Crook.