When the improbable happens
Life companies have been severely tested in the past few months.
Most of what they have had to face is not new. What is new is that a whole series of events classified as possible but not probable have happened together, which together represent the death knell for life assurance as a savings medium. Consider some of the risks that life companies have recently been exposed to:
Counterparty risk
This arises when you rely on another party to fulfil your own obligations. Readers will be all too familiar with out sourcing of administration. You telephone a UK number with a query and, with wonders of modern technology you are greeted by someone in India with a hybrid alliterative name such as Peter Patel or Sally Shah. Sometimes it is a UK call centre. Either way, the life company is relying on another company to discharge its service obligations to its customers. If the third party fails because of the credit crunch the activity has to be taken back, which requires tooling up again; or the third party has to be bailed out. If the third party is a non-UK organisation then the financial arrangement between the two parties would be subject to currency risk. This could work to the life company's advantage or disadvantage depending upon how the exchange rate moves. Of course if the third party suffers too big a financial hit then the life company might suffer one way or the other.
However the real counter party risk lies in the complex financial transactions that have mushroomed over the past 20 years. The use of swaps and derivatives has become commonplace. It first started in the early 1990s when a fall in bond yields meant that guaranteed annuity options came into money. Investment banks came up with products which attempted to match the cash flow requirements. Sometimes a better rate could be obtained if the asset was in euros. If so, the income stream in euros would have to be swapped for a sterling stream. These assets carry a market value and daily changes in them are 'marked to market'.
Lehman was a relatively big player but is no longer trading. Life companies who had assets with them will have suffered a significant loss. Other writers of these contracts, for example Goldman Sachs, are still around, but their credit quality needs to be reassessed. If this resulted in a reduction in the value that can be placed on its product then the life company's balance sheet will take a hit.
Life companies that are likely to be affected are those with guaranteed annuity option liabilities and those who have written, for example, guaranteed equity products.
Re-assurers are another source of counterpart risk and need to be vetted carefully.
Corporate bonds
Corporate bonds could be badly hit if their issuers were hit badly by the credit crunch. Spreads could widen, reducing the price of such bonds. They could also become less liquid if investors become reluctant to buy them. Old Mutual has extensive exposure to these in the US - as did Jackson National, Prudential's US arm and also Aegon's US arm - because they have large blocks of guaranteed investment products. I suspect that some of the loss is permanent as the market will not again take such an optimistic view of credit quality as they did in the recent past.
