The Soundness of Life Insurance versus Commercial Banks

Dr. Robert P. Murphy
March 23, 2023
Life Insurance, Infinite Banking, Commercial Bank, Digital Asset
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Although the phrase “money in the bank” connotes airtight safety, the recent failure of Silicon Valley Bank (SVB) and Signature Bank remind us that this confidence is misplaced. In this post I’ll first review what happened to SVB, then contrast the soundness of the life insurance sector with the commercial banks.

Rising Rates Mean Plunging Bond Prices

The Fed’s aggressive interest rate hikes posed a one-two punch for SVB. On the one hand, SVB’s depositors tended to be tech and other startup firms who thrive in a low-interest-rate environment. Throughout 2022, as outside funding for these firms dried up (because of rate hikes), they had to draw down their balances with SVB to continue meeting payroll and their other expenses. So SVB saw withdrawal outflows in 2022 that were relatively high, compared to the typical bank.

On the other hand, SVB’s assets were composed of relatively long-term Treasury and mortgage-backed securities, with an average duration in its “hold to maturity” bond portfolio of more than six years. It suffered massive paper losses on these assets as rates rose. Had SVB been able to actually hold the bonds to maturity, it could have emerged unscathed, but the massive deposit outflows meant it had no choice but to start selling and realize the losses. Once this process began, the panic snowballed as more depositors were spooked, leading to SVB’s rapid demise.

The Soundness of the Life Insurance Sector

The US life insurance sector is heavily invested in fixed-income assets. According to a September 2021 post from the Society of Actuaries, out of a total of $3.9 trillion in assets, some of the major categories were $183 billion in Treasuries, $349 billion in municipal bonds, $2.4 trillion in corporate investment-grade bonds, $157 billion in corporate high-yield bonds, and $38 billion in mortgage-backed securities (spread between residential and commercial). Moreover, the duration on these bonds was quite high; for example the average maturity of the life insurance sector’s Treasuries clocked in at 12.6 years (see Exhibit 6).

From these statistics, one might suppose that the life insurance sector has suffered catastrophic losses (perhaps unrealized) in the face of rapid Fed hikes. But this overlooks the fact that the life insurance sector’s liabilities have also been reduced in light of higher rates. Remember, a life carrier is in the business of collecting premium payments today (and in the near future) in order to invest in assets that will be able to fund a death benefit payment in the distant future (actuarially speaking). In the limit, if carriers knew exactly when an insured would die and used the premium payments to buy corresponding assets that would mature at the exact needed time, then rising interest rates would be completely irrelevant, as “paper reductions” on the Assets side of the balance sheet would be perfectly matched by the same reductions on the Liabilities side.

In reality, of course, various frictions — including the obvious fact of the uncertainty of death benefit claims — prevents such theoretical perfection. In practice, matching the duration of assets and liabilities is a key challenge of the life insurance business. We can see this in the form of a recent Deloitte survey on the topic, academic articles on the theory of life insurance asset/liability matching (e.g. here and here), and guidance from the National Association of Insurance Commissioners (NAIC) on the implications of rising rates and stress tests for companies to evaluate their risk.

Policy Loans and Surrenders

In addition to the core function of providing a death benefit, permanent (or “cash value”) life insurance policies also provide liquidity during the life of the insured. Specifically, if the owner of a suitable policy wishes to access cash, he or she can do so using a policy loan (where the cash surrender value serves as collateral), or a partial or complete surrender of the policy.

Although extreme economic events could lead to excessive demand for policy loans and/or surrenders, even here there is a margin of safety for the life insurance sector. In the first place, every month the carriers have a wave of incoming premium payments on the in-force policies. This flow of revenue would normally be channeled into assets (such as the bonds described above), but in the presence of policy loan requests, they would first satisfy those claimants. From the life insurer’s perspective, policy loans are the safest asset possible, because the carrier itself is guaranteeing the value of the collateral. (Even if the borrower never pays back the loan, it continues to roll over at interest, and is “paid back” out of the gross proceeds when the policy is either surrendered or the insured dies.)

Moreover, as an added failsafe, the typical permanent life insurance contract has provisions whereby the policy loan interest rate resets periodically based on market conditions. The insurance carriers will not find themselves in a position where the average policyholder can borrow from them at (say) 5 percent and buy Treasuries yielding 8 percent; the contractual provisions are designed to avoid this type of arbitrage scenario.

Regarding surrenders, we should keep in mind that any life insurance policy can only be originated where there is an insurable interest. Although there are many aspects (particularly for cash-value policies) of these contracts that are appealing from a purely financial perspective, we are still talking about life insurance. In an extreme economic environment many policyholders might be tempted to engage in a partial or full surrender, but they would be forfeiting the death benefit protection that was ostensibly the original rationale for taking out the policies. Moreover, depending on the situation there could be significant tax consequences from surrendering the policy early, rather than holding it until the death of the insured. These considerations provide added protection for the life carriers.

Insurance Carriers versus the Commercial Banks

In contrast to the relative soundness of life insurance, when it comes to commercial banking there is an inherent illiquidity by its very nature (at least as structured in our current regulatory environment). The very business of modern banks rests on the premise of “borrow short, lend long.”

Specifically, depositors at a commercial bank are granted “demand deposits,” meaning they believe they have the ability to withdraw their funds at a moment’s notice. But the banks of course don’t keep the money in a vault; instead they “put it to work” funding mortgages and other investments/loans, even (in the case of SVB) conventionally safe investments such as Treasuries.

Given that commercial banks take deposits that are supposed to be immediately available, and invest them in assets that will not mature for years or even decades, they are always prone to “runs.” This is why confidence is so vital in the banking industry, and various officials are always reassuring the public that their money is “safe.” Notice that you don’t see powerful people going on TV to tell the public their money is safe with the insurance companies; they already know that.

As a postscript, I should clarify that there is nothing about banking per se that requires this inherent illiquidity. For example, there have been proposals for run-proof banks that act as a genuine “money warehouse (and charge fees to its customers for the service), or for a “narrow bank” that keeps its customers’ deposits parked at the Fed to earn the interest it pays to the other banks, while still remaining completely safe. But in both cases, the Fed rejected the proposals and refused to allow such banks access to the payments infrastructure that modern banking requires.

Given the current regulatory environment and policy decisions by the Federal Reserve, the US banking system remains inherently illiquid, where even a “strong” bank can be ruined in a day if enough of its customers decide to pull out. Although it’s not invincible, the life insurance sector rests on a much sounder foundation, as the maturity of its assets more closely matches its liabilities.

To learn more about the soundness of life insurance, please see the infineo website.

Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.

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