Drawing Lessons from the Past to Chart a Course for Insurers

Drawing Lessons from the Past to Chart a Course for Insurers

Title image

Drawing Lessons from the Past to Chart a Course for Insurers

  • Add To Interests
  • PDF

  • Looking to the Past
    Our views about how the crisis might play out for insurers and the steps they should take to build a competitive position were informed by six of the most severe financial and economic crises of the past century .  In this paper, we look at three of them: Germany’s hyperinflation of the 1920s, the Great Depression in the United States, and Japan’s so-called lost decade of the 1990s.
    Hyperinflation in Germany (the 1920s)

    Germany’s hyperinflation stemmed from an economic crisis following the First World War. Germany had financed the war effort primarily by issuing bonds and increasing long-term debt. By 1918, consumer prices were already 2.3 times prewar levels. Inflation intensified after the war, when Germany’s reparation payments far exceeded the inflow of foreign capital. Printing more currency seemed to be the only option left for the German government. By 1923, the inflation rate had reached 32,000 percent a month. Debts were effectively canceled, consumers lost their savings, and production ground to a halt. Hyperinflation subsided after a new currency was introduced and foreign capital began flowing in again.

    The effects of hyperinflation on the insurance sector varied. Life insurers had been required to invest mainly in war bonds. Inflation not only wiped out the real value of these bonds but also drove up administrative costs. Many insurers failed when premiums and investment returns could no longer cover those costs. Policies became almost worthless, to the point where the letter announcing a payout was more expensive than the payout itself, even after years of contributions. Many life insurers shut down when beneficiaries stopped picking up their policies as they matured.

    The total asset value of German insurers decreased by 88 percent during the crisis. Private life insurers were hit hard. The real value of their assets dropped from 6 billion Goldmark in 1913 to 148 million Goldmark in 1924. Property insurers were also affected. They could not raise premiums fast enough to keep pace with the soaring value of claims.

    But not all insurers suffered. As a transport insurer with a large international business, Allianz was not subject to the investment regulations that governed life insurers. It entered the life business in 1922, but unlike many of its competitors, it avoided selling foreign-currency policies backed by national assets such as government bonds. With low exposure to war bonds and no foreign debt, the company was in a strong position to take over distressed insurers. At first, it targeted P&C businesses such as credit and glass insurance. As hyperinflation set in, it began acquiring weakened life insurers. By 1928, Allianz had become Europe’s largest insurer.

    The actions of able competitors such as Allianz led to a period of massive consolidation. One-third of Germany’s life insurers disappeared as a result of the crisis. Currency reforms in 1923 and 1924, in particular, left many insurers weakened and vulnerable to takeover or collapse. By 1939, there were only 55 life-insurance companies in Germany, down from 962 companies in 1913. The number of insurance groups declined from 100 to 37 over the same period.

    The Great Depression in the United States (the 1930s)

    The current crisis bears more than a few similarities to the Great Depression, including a precrisis boom, a surge of investments driven by massive amounts of debt, highly leveraged investors, lenient accounting standards, and a permissive regulatory environment. When the bubble burst in 1929, the stock market dropped by more than 50 percent. The crisis triggered an economic slowdown that was marked by a series of bank failures, drastic reductions in production, steep unemployment, a sharp drop in wages, and the imposition of protectionist measures, which stifled trade.

    U.S. life insurers did surprisingly well during this period. Strict regulation meant that their assets were invested mainly in government bonds, mortgages, and real estate. They had no significant exposure to the stock market and suffered practically no direct losses from the financial crisis. In fact, the downturn actually fueled demand for life insurance, as people shifted their money into safe havens.

    But insurers were not completely insulated from the Depression. Widespread poverty led to liquidity challenges. People let their policies lapse at an alarming rate; others began borrowing heavily against their policies. State governments and regulators eventually stepped in and limited borrowing against policies and provided access to liquidity. As a result, only 20 insurers failed, representing less than 2 percent of all liabilities to consumers. The failed companies were all either active in banking or had bad investment policies.

    Japan’s Lost Decade (the 1990s)

    In the late 1980s, Japan’s economy was dominated by asset bubbles in stocks and real estate. The Nikkei 225 almost tripled between January 1985 and the end of 1989, when it peaked at nearly 39,000 points. By 1993, it had fallen to 17,000 points. Similarly, the housing price index for major cities peaked in 1991. By 1993, it had declined by 25 percent.

    When these two asset bubbles burst, they triggered a financial and economic crisis that led to a period of anemic GDP growth—Japan’s lost decade. The crisis had a profound impact on banks, but it also marked a turning point for the insurance sector. At first, the turmoil affected insurers mainly by diminishing their real-estate and equity investments; insurance companies were weakened, but none became insolvent. However, the turmoil eventually had a much more fundamental impact on the industry.

    As a result of the crisis, Japan’s economy swung from a high-interest-rate to a low-interest-rate environment. Returns on new business were guaranteed at or even slightly above the yields on ten-year government bonds. These guarantees declined from 6.25 percent at the beginning of the 1990s to 1.5 percent in 2000. Guarantees on the industry’s massive in-force book, however, remained the same. In general, returns on most asset classes became structurally low. The 25 percent decline in the housing market in the early 1990s was only the start of a drop in real estate prices that continued for 15 years, with overall declines sometimes reaching as high as 80 percent. Finally, the Nikkei index remained volatile, falling to below 10,000 points in 2001. As a consequence, average guarantees to policyholders declined much more slowly than returns on investments.

    The damage to insurance companies became apparent when the government started cleaning up accounting standards and increasing transparency requirements. Solid solvency ratios suddenly became critical to avoiding policy cancellations and attracting new business. Insurers that had weak ratios suffered from a high rate of lapses and a lack of new business, which undermined efforts to cross-subsidize losses in the in-force book. Eight insurers failed between 1997 and 2001. A total of 10 million policies, representing about 10 percent of the assets in Japan’s life-insurance market, were affected. The sector as a whole lost $11 billion in 2001 alone.

    The government initiated efforts to recapitalize the in-force books of failing companies that were being taken over by competitors. The acquirers cut the guaranteed amounts on the policies of these companies—sometimes by as much as 10 percent—before taking them onto their books. At the same time, future interest guarantees were lowered significantly (from 6.25 percent to as little as 1 percent).

    Later, new business was increased by entrants that had waited until in-force books were recapitalized and then moved aggressively. AIG, for example, took over one of the failed companies and gained access to attractive distribution channels. It became the strongest foreign player in Japan by importing its marketing and product innovations and focusing on variable annuities, with their mix of a guaranteed principal and upside potential. As a result, the volume of life insurance premiums dropped only moderately during the lost decade, despite the crisis. By 2007, three multinational players that were active in variable annuities were among the ten largest life insurers in Japan.