Peter Dawkins:
Welcome to the Industries in Motion Podcast from RBC Capital Markets, where we take the time to explore what's new and what's next in today's fast moving markets, to help you stay ahead of the curve. Please listen to the end of this podcast for important disclosures, on this podcast was originally recorded on March 22nd, 2023.
My name is Peter Dawkins and I'm the product manager here in London, UK. And I'm very lucky today to be joined by Gordon Aitken, who heads up our European insurance coverage. So thank you very much for being here today, Gordon.
Gordon Aitken:
Thanks for having me, Peter.
Peter Dawkins:
And I think this will be a very poignant discussion that we'll be having today because I want to talk to you about perhaps the key differences between insurance companies and banks. And given what's gone on over the last few weeks, with the collapse of SVB, the acquisition of Credit Suisse, and the ongoing market turmoil, I think it'd be really helpful if we could just step back and maybe discuss what your observations have been with respect to the insurance market while all of this has been happening.
Gordon Aitken:
Yeah, sure. It's been quite an event for a couple of weeks and it's one that really nobody saw coming. So the collapse of Silicon Valley Bank, absolutely, investors were nervous and bank's shares took quite serious downturns. But insurance was very much grouped into that. And really, in that reaction in the first couple of weeks, the insurance companies didn't actually fare really any better than the banks. And I think what we're going to talk about today is that the event that caused the events at Silicon Valley Bank, and then subsequently at Credit Suisse, simply could not happen at an insurance company.
Peter Dawkins:
And I think to pick up on that, those events that caused that, as I understand it, it's a run on the bank. And so, maybe you can just give a high level overview of what a run on the bank is and what that might mean for an insurance company.
Gordon Aitken:
Sure, yeah. Run on the bank, and I think we have this image or a tail of customers around the block waiting to withdraw their deposits. It's not really like that these days, of course, it's all digital. But that's a situation where customers have deposited money and they want that money back.
If you think about an insurance company, the event that causes a customer to claim is not one that they choose. It's you crash a car or your house floods. On the life side, unfortunately you die. But these are not events, of course, that customers can pick the time of. With a bank, it's quite different. If a customer chooses to withdraw his money, he can do it any one point of time.
Peter Dawkins:
Okay. So as you've explained it, all of these issues are really being caused by a customer showing up to the bank, taking the money out. And so, that's a liquidity issue. Why can't that happen at an insurance company?
Gordon Aitken:
Yeah, that's a good question. The issue that banks, or the big risk that they face is liquidity, as you say. The actual issue for insurance companies is solvency. And you can kind of simplify those two by saying liquidity is paying the first customer, solvency, which is insurance company's issue, is paying the last customer. In fact, insurance companies are absolutely awash with liquidity. And I think evidence of that is, of course, the [inaudible 00:03:16] budget last year, when there was this LDI crisis, and insurance companies had no problems posting large amounts of collateral, which required a lot of liquidity.
Peter Dawkins:
I think that's a really excellent way of putting it. Banks have liquidity issues, insurance companies have solvency issues. But maybe we could dive a bit more into that. What makes you so confident that insurance companies don't have liquidity issues?
Gordon Aitken:
Sure. It all sort of comes down to matching, matching of every institution. You want the assets to be matched with the liabilities. And with a bank, they think they know the duration of the liabilities, but in fact, if customers withdraw money quicker than the bank expects them to, which is what we've seen in this case, the duration of the liabilities comes down very, very quickly. And the assets that they have are simply too long for the liabilities. An insurance company, that won't happen. The liabilities of an insurance company are known week to week. So insurance companies know, with a huge amount of accuracy, what the liabilities will be. And that doesn't change and it's quite different to a bank.
Peter Dawkins:
So we've discussed then, we've discussed liquidity issues, we've discussed solvency issues. I think it's probably important that we also discuss credit risk and credit issues, because that's clearly played a part in what's happened here. So maybe you can walk us through credit risk for an insurance company.
Gordon Aitken:
You're absolutely right. Insurance companies invest in corporate bonds and credit risk is something that's always on top of investors' minds. I think insurance companies really learned a very valuable lesson back in '08, '09. At that time, they were overweight banks. And, of course, back in '08, '9, we maybe expected some corporate bond defaults, but that didn't happen. But I think insurance companies still learned a lesson. And since then, they've reduced their positions in the banking sector in terms of corporate debt and now pretty much across the board they're underweight banks.
Peter Dawkins:
I think we saw with the additional tier one capital being written off, we did see credit events. How come the insurance companies, which as you said, hold all of these bonds, didn't experience any credit events themselves with respect to that additional tier one capital?
Gordon Aitken:
Yeah, I think one thing that's often overlooked by investors is the quality of the debt that insurance companies hold. Yes, they do hold debt, but it's all investment grade debt. And if you go back into events which have been stressful, if it's '08, '09, or even go back to '01, but things like the pandemic or Brexit, investment grade bonds just don't default. And that's what insurance companies hold.
In terms of some of the corporate bonds that have been written down to zero, especially with Credit Suisse, and what happened there was there's certain conditions that insurance companies need to have those bonds meet in order to hold them. Otherwise, it's just too expensive for the insurance companies. It's all to do with the solvency regime and the regulation that we have in insurance companies. And in the situation with the bonds that got written down to zero, they simply didn't meet the conditions insurance companies required. So insurance companies, really across the board, did not hold those bonds.
Peter Dawkins:
Okay. So they didn't hold these additional tier one bonds because of the regulatory regime. What was it about those bonds or the regulations that resulted in the insurance companies not wanting to hold that additional tier one capital?
Gordon Aitken:
It's all about cash flows. And the bonds that we're talking about here, the cash flows weren't guaranteed. They could convert to equity. And that was the problem. So insurance companies, to get this sort of solvency benefit, they needed to have guaranteed cash flows, and that simply wasn't the case.
It's also worth saying that in the situation we had with Credit Suisse, Credit Suisse, the credit rating of that company was getting downgraded over the years. And that's another, [inaudible 00:07:15] back to what we're talking about a minute ago, where we're say insurance companies only invest in the very best credits. Maybe they did have some Credit Suisse debt several years ago, but as that was getting downgraded, insurance companies would've sold.
Peter Dawkins:
Okay. And I think another thing that we should maybe discuss related to those downgrades is also credit spreads. And as I understand it, as the spreads have widened, with the elevated risk environment, we have seen, obviously, declines in fixed income prices. Do you worry about all of these bonds that these insurance companies are holding, with all of these unrealized losses? Or how should we think about all of the assets that they're holding and that have seen their prices decline?
Gordon Aitken:
Yeah, sure. Yeah, there is a mark to market on, of course, if you're talking about credit spreads widening, which we have seen over the last couple of weeks, you're going to talk about the value of those bonds falling, and that is going to impact insurance companies with their, as a mark to markets on the valuation. But we're talking about a dent here. And insurance companies, because the interest rates have risen last year, solvency levels are at all time highs.
Another very important point to make is it's only a temporary dent because insurance companies hold these bonds to maturity. So ultimately, they will get paid back. And it's also worth saying that when credit spreads widen out, as we've seen, stock markets tend to get nervous. But if you were to step inside an insurance company, find the management of insurance companies, they positively love days like that because it enables them to go out and pick up yield.
Peter Dawkins:
Okay. So that does tie back to that liquidity issue that we discussed at the beginning. And if you're not ever forced to sell bonds, you don't ever have to actually realize the losses on those bonds. So that really is one of the things that you were saying, which is a key difference.
I think, Gordon, just given the volatility going on, given the uncertainty going on right now, it might be quite helpful if you could just take a step back and, say, if you were an investor and you were in this environment, what would you be thinking about? Maybe what would you be doing and what kind of advice would you perhaps give to our listeners?
Gordon Aitken:
Sure. Yeah, the conversations we've been having over the last couple of weeks, there's a subsector, the UK annuity writers, and they've seen their share prices particularly hard hit. And what we've been telling people is that these are companies where their liabilities are very well known, and they know them week to week. Exactly what they've got to pay out. And the only thing that can go wrong with those liabilities is people live too long. And very unfortunately, that's going the other way at the moment. So that's on liabilities.
On the asset side, what the insurance companies do, they buy a portfolio of assets which provides a yield, which exactly matches the cash flows that they have to pay out in the liability side. So the only thing that can go wrong there is if one of these assets defaults. And as we were saying earlier, insurance companies only invest in the very best investment grade, and these assets don't default.
Peter Dawkins:
I think that's been a really helpful, I guess, dissection of the differences between banks and insurance companies and risks that they face. And is there anything we haven't covered? Anything that you might want to add?
Gordon Aitken:
I'd say comparing banks and insurance companies, of course, is difficult. But if I'm going to look back in time, the insurance sector has not ever, in recent memory, faced any difficulties. And one thing that has improved an awful lot in the sector is regulation and solvency. It's got tougher, which is great news for investors. We had a new solvency regime introduced in 2016. It's called Solvency II. It applies all the way across European insurance. And since that came in, no insurance companies got into any difficulty.
Peter Dawkins:
Well, thank you very much for your time today, Gordon, and I really appreciate your insights. I think it's really valuable information, especially with what's going on in the markets right now. So I just want to say thank you very much.
Gordon Aitken:
Thank you.
Peter Dawkins:
And thank you very much to our listeners and our viewers. We really appreciate you taking the time out of your day to listen to the Industries in Motion Podcast. So thank you again for your time and have a wonderful day.
Speaker 3:
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