“With the credit quality of the U.S. imperiled by the current impasse over raising the debt ceiling, insurance companies are facing increased overall risk on their balance sheets,” states A.M. Best.
The company recently announced the findings of stress testing it performed using its proprietary Capital model, Best’s Capital Adequacy Ratio (BCAR), which examined what impact a U.S. sovereign downgrade would have on the portfolios and financial strength of U.S. insurance companies.
Best said that “one finding is that insurers will have to reexamine their underwriting leverage, which they may not be able to maintain at historical levels without adversely impacting their financial strength.”
Best explained that, as they are “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.”
Therefore, even though Best said it “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.”
Best added that “while a sovereign downgrade would not, on its own, have a significant impact on the financial strength ratings of insurance companies with adequate liquidity, the situation bears consideration, especially by life insurers.
“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.).”
Addressing the broader implications of the U.S. as well as European Union members, Greece, Portugal and Ireland, which has created a great deal of uncertainty, Best indicated that it “is also inverting the historic capital flows during economic crises.”
Best explained that usually when an economic crisis occurs, “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.” However in the current situation “of downgraded European countries and a negative outlook on U.S. debt, that is not the case.”
Source: A.M. Best
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