IN 1981, Richard Kopcke presented a study indicating that the savings and loan industry would lose $80 billion to $120 billion over the following seven to 10 years. The Federal Reserve Bank of Boston economist proved remarkably prescient. Now Mr. Kopcke is sounding a somewhat quieter alarm over the status of the insurance industry.
The 1981 gloomy forecast depended on interest rates not returning to their low level of the 1960s and 1970s. They didn't. With the burst of inflation in the second half of the 1970s, lenders insisted on higher interest rates. The thrifts, stuck with billions of dollars of low-yielding house mortgages, started piling up losses, paying more for their liabilities (short-term deposits) than receiving for their assets (long-term mortgages). Congress worsened the situation by enabling S&Ls to do business in u n
familiar areas, such as business loans. The savings institutions just lost more money. Through federal deposit insurance, the taxpayer was stuck with losses that could exceed $500 billion.
Similarly, the warning in the new paper by Kopcke and a colleague at the Fed branch in Boston, Richard Randall, is conditional. It says many insurance companies could be in trouble if commercial real estate prices remain depressed, if corporate profits decline further, or if interest rates rise significantly.
Will that happen? "It remains to be seen," says Kopcke. However, Kopcke and Mr. Randall want insurance companies to be good scouts and prepare for such possibilities by adding rapidly to their capital. "The capitalization of most insurers is less than that of the 1970s, while the risks inherent in their assets and liabilities have not diminished," they state.
The Kopcke/Randall paper was presented at a Boston Fed conference on the financial condition and regulation of insurance companies earlier this week in Harwich Port, Mass. It was something of a delicate operation. Insurance companies do not have a central bank behind them, as do commercial banks or thrifts, to stem any "run." Though insurance companies do not have "deposits" in the banking sense, their customers can cancel policies, take loans on straight life insurance policies or, in the case of some i
nvestment-type policies such as guaranteed investment contracts (GIC), remove their money. Indeed, some 300 employees at the Boston Fed switched their tax-deferred annuities out of GIC's into other investments after seeing the troubles at First Executive Corporation units.
Randall analyzed risk concentrations in 11 major insurance companies. But he named only four of them - those which have already failed. These are First Executive, First Capital, Monarch Life, and Baldwin-United. The Boston Fed doesn't want to stir up a run on the unnamed insurance companies. After all, state insurance regulators had to seize the operating companies of the two "Firsts" after these companies experienced accelerating runs in the form of policy lapses and surrenders.
In effect, the Fed is saying that policyholder ignorance may be bliss - that it sees a need to give insurance companies time to make themselves fully solvent against potential dangers.
The Kopcke/Randall study does conclude, however, that "insurance companies, like banks, appear prone to develop major risk concentrations that can imperil the solvency of a significant portion of the industry, under certain economic conditions." In other words, some insurance companies have too much of their policyholder premiums invested in junk bonds, risky real estate, and interest-rate mismatches (money that can be withdrawn quickly invested in long-term assets).
At this stage, state insurance regulators can't do much to shrink any losses should these concentrations lead to real problems. The insurance industry hopes that economic recovery will revive prices for junk bonds, corporate profits, and real estate.
Further, the industry notes that it does have a system of guaranty funds to cover losses from failed companies. But the adequacy of the funds is in question.
Kenneth Wright, retired chief economist of the American Council of Life Insurance, says, "The life insurance industry is not in trouble; some of the companies are in trouble. But the troubles of those few companies present very real problems both for the industry at large and for its regulators."