Study: Life Insurers Proved Vulnerable To Credit Crisis

By Tom Gresham and Rob Meyer

Life insurers were unprepared for the widespread credit crunch of the past two years, and the industry could face additional financial repercussions for its investments in mortgage-backed securities, according to a study published in a July 2008 Competition Edition of the Geneva Papers on Risk and Insurance Issues and Practice.

The study, "Mortgage-Backed Securities and the Capital of Life Insurers: Was the Industry Prepared for the Credit Crunch of 2007-08?" demonstrates that life insurers reduced capital as they added mortgage-backed securities to their portfolios in 2003-2006. If insurers had understood the risks of the securities, they would have raised capital to reduce their vulnerability to them, according to the study.

"Insurers behaved as though mortgage-backed securities raised the quality of their portfolios," said Etti Baranoff, associate professor of insurance and finance in the Virginia Commonwealth University School of Business and lead author of the study. "Their reduction of capital indicates that they either were not aware or not concerned with the potential pitfalls of the securities."

Baranoff and co-author Thomas Sager, professor of statistics at the McCombs School of Business at the University of Texas at Austin, also examined the potential impact on life insurers if the credit ratings of the mortgage-backed bonds are lowered, and the researchers found evidence that the full implications of the insurance industry's investments in the securities have not yet been realized.

"In general, bonds carry lower risk ratings than mortgages. Bundling mortgages into securities and calling them bonds makes it appear that the bundled mortgages are less risky than they really are," Sager said. "If mortgage-backed securities were re-rated to recognize their true risks, life insurers could face the need for significant additions to capital, according to our capital-risk models."

Baranoff and Sager were awarded the Geneva Association/International Insurance Society Shin Research Award for Excellence for the study in July.

For a complete copy of the study, contact Tom Gresham, VCU Communications and Public Relations, (804) 828-6051, tmgresham@vcu.edu.