"Brexit" Update: Implications of the United Kingdom's Plan to Leave the European Union (05/16/2017)
On March 29, 2017, nine months after the United Kingdom’s (UK) historic referendum on whether it should leave or remain in the European Union (EU), Prime Minister (PM) Theresa May sent a letter to EU Council president Donald Tusk officially triggering Article 50 of the Treaty of Lisbon, thus starting the two-year process for the UK leaving the EU. Article 50, which only became law in 2009, has never been invoked, so how Brexit will proceed, how long it will actually take and what a final deal with the EU will look like (assuming one can be reached) are not yet known. Still, with nearly a year having passed since the 2016 referendum, perhaps taking the time for a more informed review of the implications of “Brexit” is warranted, especially since the UK will hold a snap general election on June 8—nearly three years earlier than required by law—that promises to strengthen the Conservative party’s majority in the House of Commons and consolidate Theresa May’s power to conduct withdrawal negotiations as she deems appropriate.
Although financial markets initially reacted as if economic shock would immediately follow a “leave” vote last June, the impact on the UK economy and financial markets to date has been restrained, and predictions of recession, higher unemployment and falling home prices have failed to materialize thus far. Instead, UK gross domestic product (GDP) grew an estimated 1.8% in 2016, just behind Germany among the G7, and unemployment continued to fall, to an 11-year low of 4.8% as of February. The only lasting negative market responses have been in UK stocks, which on balance have trailed their U.S. and European counterparts, and the British pound (GBP), which fell sharply after the vote and remains about 15% lower against the U.S. dollar (USD) and 10% lower against the euro. The weaker GBP modestly spurred headline inflation, which rose to 2.3% in February.
The long-term implications of Brexit are far from clear. Official forecasts vary, but most expect a material slowdown in growth from 2017 to 2019; the Bank of England raised its 2017 GDP growth projection to 2% from 1.4% last November, but still expects it to slow to 1.6% next year and 1.7% in 2019. Macroeconomic implications for the EU are less significant. At worst, Brexit could affect not only the British economy, but also the political stability of the UK. Nicola Sturgeon, the First Minister of Scotland, has promised to move forward with a fresh independence referendum, since most Scots want to remain within the EU. In Northern Ireland, Sinn Fein, which has been gaining popularity, has called for a referendum on reunification with the Republic of Ireland, although polls show a majority still prefer to remain in the UK.
The impact of the Brexit process on world financial markets is difficult to isolate from the larger context of diverging economic and interest rate trends in different parts of the world, a heightened focus on policy risk that extends beyond Brexit and the U.S. presidential election, to include France and Italy, most notably, and other global economic and geopolitical factors. The following includes a recap of the key financial market effects of the Brexit vote in recent months, as well as some related key market risks for the next couple of years.
As Chart 1 shows, following Britain’s vote to leave the EU, government bond yields fell (and thus prices rose) as investors sought safety. This initial flight to quality was short-lived, however, as other macroeconomic and geopolitical factors held sway; 10-year yields began to rise, and yield curves began to steepen late in 2016, as the one-year to 30-year spread in most major government markets widened significantly on worries that central bank bond-buying programs would wind down, increased fiscal spending would lead to more long-term debt supply, and global inflation would pick up. Thus far in 2017, the major government yield curves have been quite stable. With economic growth expectations in the EU, the UK and Japan, and inflation still shy of central banks’ objectives, bond investors expect easy monetary policies and central bank bond purchases to continue for now, keeping a lid on long-term yields.
Chart 1: 10-Year Government Yield, Select Advanced Economies (12 Months Ending May 9, 2017)
Currency Exchange Rates
As Chart 2 shows, the GBP fell 16% after the June 23 referendum, hitting a three-year low in October of 1.10 against the euro. Since then, the GBP has recovered a bit and has been largely range-bound between 1.15 and 1.20; against the USD, the GBP has mostly remained in a $1.20 to $1.25 range, near its post-referendum low, although in recent weeks it has inched higher against the USD, to about $1.29. The weaker GBP supports UK exports and tourism but raises the risk of importing inflation; raw materials, fuel and producer price inflation are accelerating, but British consumers have yet to be significantly affected by higher prices.
Chart 2: GBP to USD, EUR Spot Exchange Rates (12 Months Ending May 9, 2017)
As Chart 3 shows, the Brexit vote briefly increased credit risk concerns because of the heightened potential for negative economic consequences and increased operating costs for many companies. Following the “leave” vote, all three major rating agencies—Moody’s Investors Service (Moody’s), Standard & Poor’s (S&P) and Fitch Ratings (Fitch)—agreed that the decision was a credit negative for most sectors in the UK, and cut their respective sovereign credit ratings to Aa1, AA and AA from AAA, AAA and AA+. Brexit-related credit risk concerns were reflected in the credit default swap index (CDS) markets; the Markit iTraxx European, North American and Japanese indices—comprised of investment grade (IG) issuers in those markets—spiked after the vote, to 91 basis points (bps), 84 bps and 76 bps, respectively, but almost instantly recovered. The U.S. and Japanese IG indices have trended tighter and—at a respective 62 bps and 42 bps—are substantially tighter than pre-vote levels. European IG credit spreads had been range-bound between 70 bps and 80 bps, about the same as pre-referendum levels, until late April, and since then, they have converged on U.S. spreads.
Chart 3: Corporate CDS Spreads (12 Months Ending May 9, 2017)
Global stocks tumbled last June 23, losing approximately $2 trillion in market value. London’s FTSE 100 Index dropped 3.2% and was down 1.7% year to date (YTD) through June 2016 after a volatile two weeks where prices were driven by opinion polls. Global stock markets—including the UK—subsequently rallied back and generally moved sideways for the remainder of 2016, before staging another rally that is ongoing despite growing concerns that valuations are becoming frothy. UK shares have participated in this global trend, to be sure, but they have lagged their European, U.S. and Asian counterparts. As a result, while the Nikkei 225, S&P 500 and DAX indices all have risen approximately 15% to 20% over the past 12 months, the FTSE 100 is only up about 8%.
Chart 4: Select Major Stock Indices (12 Months Ending May 9, 2017)
Focus on Financial Institutions
UK and EU financial stocks were hit hard by Brexit concerns in the months leading up to and after the vote. The ongoing consensus is that the impact of Brexit will be greatest on financial institutions, on both sides of the Channel, particularly given London’s status as the world’s premier financial hub. The ramifications for EU and UK institutions will take time to sort out, but likely there will be several years of regulatory uncertainty that could depress trading, underwriting and merger activity, thus cutting into fee revenue, while currency volatility could hurt foreign exchange (FX) trading. Ultimately, negotiations between the UK and EU will determine how much harder it will be for UK firms to engage in cross-border business with the EU, and whether immigration restrictions will hamper their ability to hire European staff. The outcome will affect British institutions, as well as foreign institutions with European operations concentrated in London.
It is likely there will be some negative impact if UK-EU negotiations fail to produce a clean resolution to issues such as the EU financial “passport”—a legal device that allows financial services companies based and regulated in one country within the EU or the broader European Economic Area (EEA) to conduct business in other member states solely on the basis of their home state authorization. At this juncture, the simpler solution, which would involve joining the EEA single market, seems unlikely because in doing so, the UK would have to accept free movement and rulings from the European Court of Justice, with no representation in the EU’s regulatory bodies. A more likely—albeit less efficient and more costly—solution is that UK firms would set up subsidiaries in the EU that would have passport privileges.
As an alternative to passporting, the UK and EU could pursue an agreement based on the principle of equivalence, which would preserve each regime’s access to each other’s market without requiring them to mirror each other’s laws and regulations. However, there are no current provisions in EU law for equivalence in either commercial banking or primary insurance, and under EU law, a declaration of equivalence can be easily revoked. To ensure financial system stability, a very detailed agreement would have to be worked out.
U.S. Insurer Exposure to UK Issuers
As of year-end 2016, U.S. insurers’ unaffiliated exposure to UK debt and equity totaled $102.9 billion, with $98.7 billion in bonds and $4.2 billion in stocks. That represents a modest decline from 2015 year-end exposure of $109.8 billion, comprised of $105.4 billion in bonds and $4.4 billion in equities. About 85% of 2016 year-end exposure was U.S. dollar-denominated, with another 9% in GBP. UK bonds represented about 17% of the U.S. insurance industry’s foreign bond exposure (approximately $582 billion) at year-end 2016, second only to Canada (18%). Exposure to UK sovereign debt accounted for 16% of UK bond exposure, while financial bonds made up 27%. UK equities were the largest foreign stock exposure for U.S. insurers, at 17% of total foreign stock exposure; 9% of UK exposure was in financial stocks, whereas 25% was in energy and 18% in basic materials.
As the Brexit situation evolves over the next two years (or longer), its actual impact on markets and economies will become clearer, including secondary and tertiary impacts on other EU countries. These impacts include concerns—however remote—that populist/nationalist movements in continental Europe could raise policy risks and might even threaten the fabric of the EU. While recent electoral results have eased these fears, most notably Emmanuel Macron’s victory over Marine Le Pen in France, some populist/nationalist influence remains part of the EU political landscape.
From the perspective of the U.S. insurance industry, the impact should be relatively modest. The U.S. insurance industry’s investment exposure to the UK is significant but not extraordinarily so, and to the extent that UK entities engage in transactions with U.S. insurers, it is often through a U.S. legal entity.
The NAIC Capital Markets Bureau will continue to monitor these developments and report as appropriate.
Markets React to Surprise U.S. Presidential Election Outcome (11/09/2016)
The initial reaction of world financial markets to the U.S. Presidential election results on Nov. 8, 2016, was extreme and severely negative, beginning well before final results were determined even as the chances of victory for former Secretary of State Hillary Clinton diminished. As victory by Donald Trump became more certain, U.S. stock futures, evidenced by the Standard & Poor's 500 Index, had dropped by 5% and several market circuit breakers were triggered. The negative reaction was generally attributed to uncertainty with now President-elect Trump, as opposed to the relative known quantity of former Secretary Clinton. This immediate reaction began reversing in early hours this morning, and most market levels had significantly recovered by the market open in the U.S. Not only are investors uncertain about how Trump's economic policy proposals (e.g. tax cuts and spending to stimulate growth and inflation) would impact the financial markets, but they are also concerned about proposals he made during his campaign that could cause major shifts in trade and immigration. In addition, investors are concerned about geopolitical implications. Asian equity markets closed overnight down 5%. European markets recovered (the Stoxx Europe 600 was up 0.7%) after opening with a steep drop. Government bond prices and oil prices showed similar volatility. Given concerns about trade issues, foreign exchange rates also reacted. A brief review of each of the major markets is as follows:
Global stocks tumbled initially this morning but have rallied back into positive territory in Europe and the U.S. Late last night, the S&P 500 Index futures experienced a 5% decline as the very close presidential election brought about uncertainty. The S&P 500 Index opened this morning down only 0.5% as election uncertainty ended, and is currently up 1.3%. Since Sept. 30, the S&P 500 has dropped 0.1% as of today, but it is still up 6.0% year to date (YTD). The S&P 500 Index has been volatile in recent days as the fortunes of the election shifted back and forth. The Asian stock markets led the declines today with the Japanese Nikkei 225 stock index down 5.4% (futures indicate +4% recovery), the Hong Kong's Hang Seng Index down 2.2% and China's CSI 300 down slightly by 0.54%; YTD, the Nikkei 225 is down 14.6%, the CSI 300 is down 10.1%, but the Hang Seng is up 2.3%, all in local currency terms. In Europe, the London's FTSE 100 Index initially opened down 1.4%, but has since recovered to close up 1%, slightly break even since Sept. 30 but up 10.7% YTD in local currency terms. The German DAX Index is up 1.6%, and the French CAC 40 is also up 1.5%, although both are down YTD at -0.9% and -2%, respectively.
The hardest hit sectors today within the S&P 500 Index were the more interest rate sensitive utilities (-3.2%) and real estate (-2.4%), as well as the defensive consumer staples (-1.5%). Higher were financials (+3.2%) as they could benefit from a steepening yield curve, and healthcare (+2.8%) from perceptions that Trump would exert less pressure to lower drug prices – or let the free market set prices.
U.S. insurer investments in unaffiliated common stock totaled $305 billion in book/adjusted carrying value (BACV), or roughly 6.2% of unaffiliated invested assets at year-end 2015. The table below represents total invested assets as of year-end 2015.
Government Bond Yields
U.S. Treasury yields experienced significant volatility as the world awaited the U.S. presidential election results. Last night, 10-year U.S. Treasury yields plunged 14 basis points (bps) to 1.71% as global equity markets sold off with the uncertainty of the election outcome. However, yields rebounded (and prices dropped) as it became clear Trump would win the White House; 10-year yields rose 34 bps to 2.05% (or 20 bps higher than the previous close) on expectations that Trump's fiscal policies will lead to increased spending and debt. The differential between the 30-year and 12-month U.S. Treasury yields has steepened to 216 bps, from 173 bps on Oct. 1, on expectations that inflation will begin to accelerate. U.S. insurance companies, particularly life insurers, benefit from steeper yield curves given their long-dated liabilities. Although the yield curve is not as steep as it has been in past years (in the 300 to 400 bps range), it is beginning to move in the right direction. Offsetting the benefits of a yield curve steepening, however, is the expectation that interest rates might stay lower for longer than expected. Expectations for a rate hike in December are unclear with the recent market volatility and the uncertainty of a Trump administration; overnight, the Fed funds futures had indicated a less than 50% probability of an imminent rate hike but are now back to an 80% probability given inflation concerns and the pull back in Treasury yields.
Movement in global government bond yields was muted, with German and UK 10-year yields rising two bps to 0.20% and 1.25%, respectively and Japanese 10-year yields unchanged at -0.08%.
Investment grade credit default swap (CDS) spreads jumped from yesterday's close of 75.8 bps to 79.9 bps at today's open before rallying down to 75.7 bps by 1:00 pm. Over the past month, investment grade CDS spreads ranged from 73 bps on Oct. 24 to Friday's high of 81 bps. The high over the past year was 124.6 bps on Feb. 11.
High yield CDS followed a similar path jumping from 409 to 426 bps before rallying back to yesterday's 409 bps. Their one-month range was 394 to 436 with a one-year peak of 589, also on Feb. 11.
U.S. insurance industry bond exposures totaled $3.9 trillion BACV at year-end 2015, with $2.1 trillion BACV in corporate bonds. Overall, both exposures are heavily skewed to investment grade: 94% of total bonds and 91% of corporate bonds. Of the investment grade exposure 71% of total bonds and 48% of corporate bonds carry an NAIC-1 designation.
Stock Market Sector Reactions
Relative to the U.S. stock market's overall response, there has been considerable disparity between market sectors as investors sort out the likely ramifications of policy goals, specifically fiscal stimulus in the form of tax cuts and increased infrastructure and defense spending, restrictions on free trade and immigration, and a rollback of regulation on businesses. Overall, it appears initial fears that more restrictive trade policy would choke economic growth have been offset by potential short-term benefits of increased government spending, although the longer-term effects of a tougher stance on trade and immigration would be inflationary.
Financials are the day's best performers thus far, rallying on the prospects that the regulatory burdens placed on banks and other institutions by Dodd-Frank and the Labor Department's fiduciary rule could be lifted and that higher deficit spending steepens the yield curve. Healthcare stocks—mainly biotech and pharmaceuticals—are higher on prospects that that the new administration will refrain from controlling drug prices, and on the defeat of California's Proposition 61, which sought to limit what state agencies pay for prescription drugs to what the Department of Veterans Affairs pays. Probable headwinds if the Affordable Care Act is repealed or changed are weighing on managed care stocks, however. Industrials are higher on prospects for boosts in defense and infrastructure spending. Materials stocks are higher, most likely on prospects for a tougher U.S. stance on trade and perhaps increased demand down the road from infrastructure spending. Energy shares are up, but prospects for the sector are more nuanced; a roll-back of regulations and potential opening of federal land to drilling would be welcomed by exploration and production companies because of the potential to produce more barrels at lower cost, while pipeline companies would benefit from higher volumes. Still, the potential negative impact on global growth of protectionist policies could crimp oil demand, increasing the likelihood that the oil glut continues and depressing oil prices again, and the uncertain geopolitical ramifications of a Trump presidency could be a wild card for oil prices. Coal stocks are bouncing because of Trump's relaxed stance on climate change, although coal likely will struggle to compete with cheap natural gas under a fracking-friendly regime.
Currency markets, as they often do in reaction to uncertainty, were also rattled. The U.S. dollar initially plunged on the news but not long after, it began to rebound. The WSJ Dollar Index, which measures the dollar against 16 other currencies, was down by as much as 0.8% overnight but had recovered much of that by morning. Emerging market currencies also fell as traders sold off riskier assets in favor of safer ones. The Mexican peso was the biggest loser, tumbling to its weakest level on record on fears that Trump would follow on his pledges to end the North American Free Trade Agreement (NAFTA) and deport millions of immigrants from the U.S. Nearly 80% of Mexico's exports go to the U.S. The Canadian dollar also tumbled to an 8-month low on investor concern that the end, or renegotiation, of NAFTA could reduce trade between Canada and the U.S. The U.S. is Canada's largest foreign market, and it is the biggest foreign investor in Canada. Trump's speech earlier today seems to have calmed market nerves, at least somewhat and for the time being, as he appeared to be more conciliatory in his first official address.
Custodian Banks: Risks are Manageable with Appropriate Safeguards (11/01/2016)
The U.S. insurance industry typically employs third-party service providers for a variety of day-to-day operations, particularly within the investment management process. A critical third-party service provider to insurance companies is the custodian bank, whose primary role is to hold in safekeeping the assets of its clients. The use of custodian banks is a customary and common market practice used by most, if not all, market participants, both on the institutional and retail side. Other key custody services and responsibilities include: 1) providing daily and/or monthly pricing of assets; 2) monitoring and posting income and principal payments; 3) settling securities transactions; and 4) providing recordkeeping and reports of assets in custody. Custodian banks offer the convenience of monitoring and storing assets electronically, minimizing the risk of loss or misplacement to physical security certificates. In addition, custodial services provide efficiency to clients in that they significantly reduce the in-house resources and expertise needed to handle middle- and back-office operations; for example, the back-office operation faces one entity—the custodian bank—instead of many. Custodian banks also provide standardization of post-trade settlement and monitoring processes, resulting in more efficient business practices overall.
The National Association of Insurance Commissioners (NAIC) developed specific guidelines related to custodian bank relationships and custodial agreements in the Model Act on Custodial Agreements and the Use of Clearing Corporations (#295) and the Model Regulation on Custodial Agreements and the Use of Clearing Corporations (#298). Model #295 “authorize[s] domestic insurance companies to utilize modern systems for holding and transferring securities without physical delivery of securities certificates,” while Model #298 offers specific requirements insurers should consider when choosing a custodian bank and entering into a custodial agreement. Because these models are not required for accreditation purposes, many states have not yet adopted them, and their domiciled insurers do not have to meet the models’ requirements. However, the NAIC’s Financial Condition Examiners Handbook incorporates many of the models’ specific requirements to provide examiners of insurance companies comprehensive guidance on how to adequately evaluate and assess the appropriateness of custodial agreements.
U.S. insurance companies provide information related to their custodian bank relationships and custodial agreements in the investment section of the general interrogatories of the annual financial statements, with data points collected on five questions specific to the topic. However, the data and information reported is somewhat limited and, therefore, difficult to draw definite conclusions from. Nonetheless, based on the limited data as of year-end 2015, the majority of insurance companies appear to be operating under custodial agreements that generally follow the specific guidelines suggested by the two NAIC models. Of the almost 4,500 CoCodes answering the question “Were all stocks, bonds and other securities … held pursuant to a custodial agreement with a qualified bank or trust company?” 93% of the reporting CoCodes replied “Yes.” This general interrogatory allows examiners to identify where additional focus and questions are needed to gain comfort in the suitability of custodial agreements.
For the custodial agreements that comply with NAIC requirements, insurers provided the names of their custodian banks; note that one insurer can have more than one custodian bank relationship. Almost 50% of the industry’s reported custodial agreements were with large, national banks such as Bank of New York Mellon, J.P. Morgan Chase, Wells Fargo, State Street and Bank of America. Regional banks such as U.S. Bancorp, M&T Bank, Comerica Bank and PNC Financial represented 20%, while foreign banks (or their subsidiaries operating in the U.S.) such as Bank of Tokyo-Mitsubishi, UBS and Royal Bank of Canada represented 5%. The remaining balance, or 28%, consisted of local banks and non-bank financial institutions.
As with any third-party service provider, several risks should be considered when insurance companies enter into custodial agreements. Counterparty risk—the risk faced by one party that the other party will not satisfy the obligations of the contract—is a main concern, but it is a common risk that arises when entering into investment transactions. Custodian banks are typically selected based on not only their expertise and strength of operational procedures and controls, but also on their financial strength and stability. Model #298 defines a custodian as “a national bank, state bank, federal home loan bank or trust company that shall at all times … be no less than adequately capitalized as determined by the standards adopted by the regulator charged with establishing standards for, and assessing, the institution’s solvency” or “a broker/dealer that shall be registered with … the Securities and Exchange Commission, maintains membership in the Securities Investor Protection Corporation, and has a tangible net worth equal to or greater than” $250 million. Both definitions should ensure that insurers enter into custody arrangements with custodian banks that are adequately capitalized.
Approximately 75% of the industry’s reported custodial agreements are with large, national or regional financial institutions that are regulated by a banking regulatory authority such as the Federal Reserve, the Office of the Comptroller of the Currency (OCC) or the Federal Deposit Insurance Corporation (FDIC). These financial institutions dominate the market, and barring any significant changes to their financial strength, counterparty risk in this case should be minimal. However, the insurance industry also enters into other financial transactions—derivative transactions, in particular—with many of the commonly used custodian banks, which could potentially result in heightened risk if there is a particular concentration of financial transactions with any one financial counterparty. Diversifying custodian and other financial relationships can, therefore, mitigate the risk of a significant loss in the event of one counterparty’s failure. Having said that, assets held in custodial accounts are protected against a custodian bank’s insolvency in the U.S., whereby those assets are not subject to the claims of general creditors. Custodian banks also are subject to enhanced supervision and prudential standards under the federal Dodd-Frank Wall Street Reform and Consumer Protection Act, whereby they must ensure key systems and services continue to operate until custodial assets can be transferred to another custodian bank as part of their resolution plans.
Outsourcing services to custodian banks also can lead to operational risks wherein losses materialize as a result of: 1) trades not processed or settled properly; 2) data not appropriately stored or safeguarded; 3) records not accurately maintained; and/or 4) assets not appropriately segregated from assets of other custodian accounts. As custodian banks typically possess a significant level of operational expertise and scale, the first three operational risks listed above are relatively minimized. However, at the same time, these operational risks can still arise—and possibly be heightened—given the large volume of transactions that custodian banks process on a daily basis. In addition to the fiduciary duty each party owes to the other given the contractual-based relationship, the Financial Condition Examiners Handbook outlines a number of safeguards and controls that custodial agreements should contain and examiners should verify during examinations to limit such operational risks. Suggested safeguards include: 1) indemnification for any loss of securities in the custodian’s custody; 2) replacement of securities or value of securities; 3) examination of custodian records upon written notice; 4) maintenance of records and information relied upon by the insurance company for the preparation of its annual statement and supporting schedules; and 5) the restriction that foreign banks be allowed to hold foreign securities only. Note there is no explicit safeguard related to asset segregation.
An added risk relates to a common market practice wherein securities are held “in street name,” meaning the owner listed on the security certificate—where the market norm is to hold assets in electronic form, rather than physical certificates—is not the specific investor but the bank, broker, custodian or trust company that the investor uses to purchase the security. The bank, broker, custodian or trust company maintains records to track the investor who is the “beneficial” owner. This practice provides convenience, efficiency and safety. It allows for: 1) ease of transfers when a security is bought or sold, thereby speeding up the trade settlement process; and 2) the ability to hold securities electronically, reducing the possibility of physical damage, loss or theft of the security certificate. Although there might be a perceived risk in doing so, holding securities “in street name” is a common market practice that streamlines the investment process and provides cost efficiencies to all market participants. Furthermore, assets held by banks in a custodial capacity do not become the assets of the bank and should be maintained separately from the bank’s assets.
Because the use of custodian banks is a standard market practice, the risks outlined above are broad market concerns that not only insurance companies face, but also other institutional investors and retail investors. However, these risks can be managed or reduced if: 1) custodian relationships are diversified; and 2) appropriate safeguards and precautions are included in custodial agreements as suggested in Model #295, Model #298 and the Financial Condition Examiners Handbook.
Government Bond Yields Reach a 30-Year Low (07/05/2016)
Beginning the second half of 2016, government bond yields have continued their decline and have reached their lowest point in 30 years. As a result, yield curves have flattened, with differentials between the 30-year and one-year at 180 basis points (bps) in the U.S. and only 42 bps in Japan. Japanese and German government bond yields are negative going out past the 10-year point in the curve, and the European Central Bank (ECB) curve is negative out to the 5-year point. Estimates indicate that there are currently more than $11.7 trillion in government bonds globally with a negative yield.
U.S. Government Bond Yields (30-Year and 10-Year) Since 1986
Global Government Bond Curves as of July 1, 2016
Year–to-Date Change in Government Bond Yields as of July 1, 2016
What does this mean for reinvestment yields?
After brief spikes following the United Kingdom (UK) referendum to leave the European Union (EU) on June 23, 2016, U.S. credit spreads retraced, and as of July 1, 2016, they were at roughly 75 bps for investment grade and 415 bps for below investment grade. Using U.S. credit spreads as a simple benchmark, U.S. 10-year corporate bonds are yielding about 2.25% for investment grade and 5.5% for below investment grade. Credit spreads are modestly wider in Europe. However, with government bond yields substantially lower, 10-year German corporate bonds now yield less than 1%. With the 30-year bund only 50 bps higher, longer-dated German corporates are not faring much better. The differential between investment grade and below investment grade also is not significant; while wider than a year ago, the current differential is only 340 bps.
U.S. Corporate Bond Spreads (Investment Grade and Below Investment Grade CDX)
The spread differential between different government bond yields has changed somewhat since the beginning of 2016. Focusing on the 10-year point in the government bond curves, UK gilts are yielding 0.88% versus U.S. Treasuries at 1.46%, or a differential of 59 bps. This represents an increase from 31 bps at the end of 2015. Comparisons of the spread differential between U.S. 10-year Treasuries with other major government bonds have moved in the opposite direction. The differential with Germany has narrowed 6 bps points (159 bps versus 164); with Japan, it has narrowed 29 bps (172 bps versus 201); and with the ECB, it has narrowed 11 bps (90 bps versus 101). These statistics have implications on currency exchange rates, which will affect companies with international operations to the extent their revenues and earnings are not stated in U.S. dollars.
Euro Versus U.S. Dollar, July 1, 2011–July 1, 2016
U.K. Government Bond Yields (30-Year and 10-Year) as of July 1, 2016
German Government Bond Yields (30-Year and 10-Year) as of July 1, 2016
Japanese Government Bond Yields (30-Year and 10-Year) as of July 1, 2016
The NAIC Capital Markets Bureau will continue to monitor trends within government yields and report as deemed appropriate.
Implications of the United Kingdom Referendum to Leave the European Union (6/24/2016)
As scheduled on Thursday, the United Kingdom (U.K.) held a referendum on whether or not to leave the European Union (EU), informally referred to as the “Brexit”. As previously discussed in a Hot Spot published on June 7, the expectations for which way the referendum would go has varied significantly and in the last week leaned in the direction of staying in the EU. The actual result was a vote in favor of leaving. Following the vote, Prime Minister David Cameron announced his resignation. He has also said that the actual act of triggering Article 50, the provision to notify the EU that a country has decided to leave, should be left to the new Prime Minister. There is not much in terms of specifics as to how a country can disengage from the EU except that there is a time period of two years once Article 50 is triggered. The market reaction so far has been dramatic. While financial systems globally seem to all be operating properly, markets worldwide are reacting negatively to the news.
Following Britain’s vote to leave the EU, government bond yields are lower (and prices are higher) as investors seek safety during this period of global financial uncertainty. U.S. Treasury yields experienced their largest declines since 2009, with 10-year yields dropping 18 basis points (bps) to 1.57%. The differential between the 30-year and 12-month U.S. Treasury yields narrowed to 194 bps, its thinnest margin in the last five years. Insurance companies, particularly life insurers, benefit from steeper yield curves given their longer-dated liabilities, so flatter yield curves pose significant challenges to their profitability. Globally, German and Japanese government bond yields fell further into negative territory. The 10-year bund yield dropped below zero, declining 13 bps to -0.04%, and the yield on the 10-year Japanese government bond (JGB) fell 2 bps to -0.17%. The yield on 10-year gilts (U.K. government bonds) plunged 28 bps to 1.09%, hitting record lows during the trading session. The gilt yield is higher than the bund (German government bonds) yield by 113 bps, compared to 128 bps one year ago, while the U.S. Treasury yield is above the gilt yield by 48 bps, widening from 22 bps one year ago as gilts have rallied to much lower yields over the period.
Chart 1: 10-Year Government Yield, Select Advanced Economies (June 25, 2015 to June 24, 2016)
The Brexit vote has increased concerns for credit risk given the potential for negative economic consequences as well as increased operating costs for companies. This has been reflected in the index credit default swap (CDS) markets. The Market iTraxx European and North American indices are each comprised of 125 investment grade issuers and the Japanese of forty. All three followed a similar pattern over the past 3 months. Spreads in all three regions spiked with today’s news: European spreads jumped overnight from 74.74 bps to 91.47, North America from 76.44 bps to 84.03, and Japan from 67.76 bps to 76.25. Among companies with the largest stock market value in the FTSE 100 index, 5-year CDS on Unilever jumped from 25 bps to 30, British American Tobacco from 56 bps to 61, and British Petroleum from 86 bps to 92 (after touching 103).
Chart 2: Corporate CDS Spreads
There has been volatility in sovereign CDS spreads. CDS widened on the U.K., German, and French benchmark government bonds. From May 31 to June 9, U.K. CDS were trading around 32 bps. They began a steady ascent to around 41 bps but when new opinion polls tilted towards “stay” U.K. CDS spreads fell back to 36 bps, drifting around 38 over the past few days. When trading reopened today, U.K. CDS spiked to 48 bps before falling back to 42.4 around New York’s 8:00 AM open. CDS on German and French bonds showed a similar pattern: Germany was up 2.5 overnight to 21.3 bps and France was up 13 to 49.2 bps. Corporate spreads in Europe (the index includes U.K.), North America, and Japan each made similar jumps on today’s news.
Global stocks tumbled today losing approximately $2 trillion in market value. London’s FTSE 100 Index dropped 3.2% today (as of 12:30 PM U.S. Eastern Standard Time) and was down 1.7% year to date (YTD), after a volatile two weeks where the markets moved with the BREXIT opinion polls. From June 8 to June 14, fear of Brexit caused the FTSE 100 Index to plunge 6%, but quickly turned around and increased 7% as of June 23 as Brexit fears subsided. From the end of the first quarter until yesterday’s close, the FTSE 100 Index increased 2.6% and was up 1.5% year to date. The hardest hit sectors as of June 24 within the FTSE 100 Index included financials (-10.8%) and more cyclical sectors, such as consumer discretionary (-6.5%) and industrials (-5.6%). Meanwhile defensive sectors gained, such as healthcare (+3%), technology (+1.7%) and consumer staples (+1.1%). As of June 24, the Euro Stoxx Index of 50 stocks dropped 8.6% (YTD down 15%), the S&P 500 Index dropped 2.9% (YTD up 0.4%), and the Nikkei 225 Index dropped 7.9% (YTD down 21.4%).
Chart 3: Stock Indices from 3/31/2016 to 6/24/2016 as of 12:30 PM U.S. Eastern Standard Time
Currency Exchange Rates
The pound has fluctuated wildly since the beginning of the referendum campaign in February, reflecting the changing sentiment regarding the outcome of the vote. Britain’s vote yesterday to leave the EU sank the pound sterling (GBP) to its lowest level since 1985.
Most major currency markets moved in reaction to the vote yesterday and its potential impact on financial markets. The sterling fell to its weakest level against the euro in more than two years, with a drop early today to 1.2027 euros to GBP. It also experienced wider swings against the dollar than it did in all of 2015. The GBP has traded today to a low of 1.3229 from 1.5018 GBP versus the USD.
Other currencies have also reacted to Britain’s exit decision. Bloomberg’s British Pound Index, which tracks sterling against several major peers, tumbled by 6 percent. The yen, however, which is considered as a safe haven, at one point in the day, broke through 100 per dollar, for the first time since 2013.
The Bank of England is “monitoring developments closely” and has “undertaken extensive contingency planning and is working closely with HM Treasury, other domestic authorities and overseas central banks," to make the transition less painful.
Chart 4: GBPUSD Spot Exchange Rate
The impact is greatest on financial institutions. The ramifications for Europe’s financial institutions will take time to sort out, but it stands to reason that there will be several years of regulatory uncertainty, a likely slump in trading volumes, and especially new share listings and mergers, thus cutting into banks’ fee revenue. Currency volatility may hurt foreign exchange (FX) trading operations. One thing that seems clear is that many firms will incur significant costs as they reorient their businesses to the post-Brexit environment. Brexit may make it harder for London-based banks to do cross-border business with the EU, and possible immigration restrictions may hamper their ability to hire European staff. That not only includes British institutions, but also major European institutions that have concentrated their operations in London. Analysts at JPMorgan Chase & Co. estimate banks exposed to the U.K. could see a 20% hit to earnings with a 17% hit to pretax profit for Deutsche Bank AG and 21% for Credit Suisse Group AG. Many international firms could have to move people and operations to continental Europe as the post-Brexit regulatory scheme develops. This includes major US banks. JPMorgan Chief Executive Officer Jamie Dimon said the bank might have to change its European corporate structure and relocate staff. Ireland, the Netherlands and the Nordic countries have all positioned themselves to step in for London, and financial firms located in those countries could conceivably feel the least impact. According to Bloomberg, before the vote, Ireland's government approached banks on relocating operations to Ireland, and Nasdaq Inc. pitched the Nordic exchanges it owns as an alternative to London for initial public offerings.
There will likely be at least a couple years of regulatory uncertainty, market volatility, and a probable slump in new share listings and mergers that could cut into advisory fees and perhaps lead to trading losses. For example, Deutsche Boerse's $14 billion pending merger with London Stock Exchange Group could be at risk, as politicians in Germany's ruling parties have indicated discomfort with the deal in a non-EU U.K. Smaller and mid-sized U.K. institutions focused more on the domestic market - such as building societies - could be hurt if the economic impact of Brexit is materially negative. This could hurt revenue, profits, and asset quality. Larger firms are likely less dependent on the U.K. Volatility amid the build-up to the referendum hurt investment and hiring, according to the Bank of England, as economic growth slowed to 0.4% in the first quarter. A recession could result, according to the U.K. Treasury and BOE Governor Mark Carney; the BOE meets next on July 14 and may have to step up support with a rate cut, although the falling pound could make a rate cut more difficult. It also may not be much help if the EU also contracts, since it contains seven of the U.K.’s top 10 trading partners. Norway, not an EU member, may also be adversely affected by Brexit because the U.K. is its second largest trading partner. Financial stocks – particularly banks – were hard-hit by Brexit concerns, both today and in the months leading up to the referendum. Over the past three months, the Euro STOXX 600 Banks Index, which tracks the banking sector the broader Euro STOXX 600 Index, has fallen 9.5%, including a 14.3% decline today. By comparison, the Euro STOXX 600 index overall declined just 1.8% over the past three months, including a 6.8% drop today.
Chart 5: European Bank Stocks
Rating Agency Views
As a consequence of the “leave” vote, all three major rating agencies – Standard & Poor’s (S&P), FitchRatings (Fitch) and Moody’s Investors Service (Moody’s) – agree that the decision is a credit negative for most sectors in the U.K., including the U.K. sovereign rating. Currently U.K.’s long term sovereign debt is rated AAA/AA+/Aa1 by S&P, Fitch and Moody’s, respectively. All three rating agencies have stable outlooks on the respective ratings, but they will be reviewing these ratings and others that are potentially affected as a result of this event. In S&P’s view, the vote to leave “deter[s] investment in the economy, decrease[s] official demand for sterling reserves, and put[s] the U.K.’s financial services sector at a competitive disadvantage compared with other global financial centers.” S&P does not anticipate an immediate impact on U.K. domestic commercial bank ratings; the impact is expected to be indirect, such as through possible adverse consequences related to economic activity. Fitch views the vote to leave as a negative for most U.K. sectors because of “weaker medium-term growth and investment prospects and uncertainty about future trade arrangements”. Any medium to long-term rating actions are dependent on various factors including the size and duration of GDP impact and extent of sterling depreciation. In addition, Fitch stated that “[t]he U.K.’s status as a major international banking hub could be damaged as some business lines shift to the EU. Higher import costs and pressure on exports due to the potential imposition of tariffs would be broadly negative for corporates.” And according to Moody’s “[t]he immediate financial markets reaction has been pronounced, with sterling depreciating sharply and global equity markets falling. Under European law, the formal withdrawal process should take place over a two-year period, although this can be extended by mutual agreement.” With respect to impact on EU economies, Fitch stated that the U.K.’s post-exit trade agreements would be the main driver of the magnitude, and there would also be political repercussions, including a weakening of EU cohesion and possible negative rating actions. “Fitch would expect the main direct effect of Brexit on EU economies to be through lower exports.” In particular Ireland, Belgium and the Netherlands are most dependent on merchandise exports to the U.K., according to Fitch; and “…the EU is the market for some 44% of U.K. exports of goods, equivalent to 7% of U.K. GDP.” And the EU budget would also experience a large decrease as the U.K. was the third largest contributor.
US Insurer Exposure to U.K. Issuers
As of year-end 2015, U.S. insurers’ exposure to U.K.-domiciled debt and equity totaled $118 billion, with $105.4 billion in bonds and $12.6 billion in equities. The bulk of the U.K.-domiciled debt, approximately 81% of the total, was with nonfinancial corporates. Approximately 90% of this exposure is USD denominated with the rest in British pounds. U.K. bonds represented approximately 15% of the U.S. insurance industry’s foreign bond exposure (approximately $688 billion) at year-end 2015, second only to Canada (16%). Exposure to U.K. sovereign debt (gilts) was only 1.5% of the U.K.-domiciled bond exposure, while U.K. financial bonds were 17%. Exposure to U.K. equities was the largest foreign stock exposure for the U.S. insurance industry, at 62% of total foreign stock exposure — 3% of which was in U.K. financial stocks.
While concerns have generally been about the potential impact to the U.K. economy and therefore U.K. related investments, it is safe to say that there is considerable uncertainty about the impact of the decision to leave the EU. This includes the likelihood of secondary and tertiary impacts among the other current EU countries. Some have suggested that there may be other countries that will also consider leaving if the U.K. does. The US insurer exposure to other EU countries is detailed in Table A. Given the specific concerns related to the financial sector, US insurer exposure to financial institutions in EU countries is detailed in Table B.
Table A: Insurer Exposure to Other European Union Countries ($ billions)
Table B: US Insurer Exposure to European Financials
This will be an evolving situation over the next several days, weeks, months and perhaps even years. The actual impact on markets and economies will hopefully become clearer over time. The NAIC Capital Markets Bureau will continue to monitor developments relative to the potential Brexit and report as deemed appropriate.
Implications of a Potential Brexit (06/07/2016)
As the referendum for Britain’s exit (or Brexit) from the European Union (EU) nears, debates for and against the move are escalating. Those who are for Britain staying in the EU argue that the economic benefits from Britain’s EU membership outweigh its costs; that Brexit will slow Britain’s economic growth; that having a single European regulation scheme reduces red tape and benefits business; and that leaving the EU will not result in reduced immigration to Britain. Those that say it is better for Britain to leave the EU say that doing so will allow it to negotiate a better EU relationship; secure its own trade deals with other countries; spend EU membership budget on other priorities; regain full sovereignty; and have greater influence in the world. The decision to stay or leave will be decided via a referendum vote on June 23, 2016.
Withdrawal from the EU is a right of EU member states under the Treaty on European Union, Article 50. The treaty allows any “Member State to decide to withdraw from the Union in accordance with its own constitutional requirements.” The impending vote has raised some uncertainty relative to the impact on investments in the United Kingdom (U.K.). While U.S. insurers have some direct exposure to UK-domiciled issues, it is difficult to gage how these investments will be impacted if a Brexit were to occur. With just a few weeks to go until voting, many referendum poll results show that the vote can still go either way. According to the latest BBC News poll (shown below), the percentage of those that want to leave the EU was 48% and those who wanted to remain was 43%. The rest, or 9%, were still undecided.
EU Referendum Poll Tracker
Source: BBC News.
Concerns over the vote have already led to significant depreciation and volatility in the British pound (GBP). The GBP has whipsawed since the beginning of 2016, with the GBP to U.S. dollar (USD) exchange rate falling from 1.47 on Jan. 1, to a year low of 1.39 on Feb. 26, and partially recovering to around 1.45 on June 6. Since the beginning of the year, the GBP is down 2.19% against the USD. A decision to exit could add further uncertainty and volatility.
According to Standard & Poor’s (S&P), the referendum has already started to weigh on Britain’s economic activity, with gross domestic product (GDP) growth slowing to 0.4% in the first quarter of 2016 from 0.6% in the fourth quarter of 2015. S&P points out, however, that it is difficult to separate how much of the slowdown comes from weakness in global growth and “cyclical deceleration.”
UK government bond yields have not, per S&P, reacted to Brexit fears. Spreads between gilt and bund yields have been fairly steady at about 130 basis points (bps) since November 2015, and spreads between Treasury notes and gilts at around 35 bps.
The potential for Brexit thus far appears to have had a limited impact on equity prices. The following graph illustrates the relative performance of the FTSE 100 Index (UK) to the Dow Jones Industrial Average (U.S.), the CAC 40 (France) and the DAX (Germany) since Dec. 31, 2015. These indices have essentially been moving largely in tandem with one another.
FTSE 100 Index Return vs. Other Indices (YTD)
Brexit concerns have led Moody’s to caution that a vote to leave the EU could put the UK’s sovereign rating (Aa1/Stable) on “negative outlook.” A downgrade, it says, is possible if the country’s economic growth weakens over the medium term. Moody’s believes that an exit would be “credit negative” for insurers operating in the UK, but the negative effect on insurers’ credit fundamentals would be “relatively modest.” S&P, which has maintained a rating of AAA for the UK since 1978, changed its outlook to negative in June 2015 on worries that an exit would add significant risk to the UK’s economy, its financial services sector and its exports. S&P also stated that it “could lower the rating by more than one notch if we reassessed our view of the UK’s institutional strength and ability to formulate policy conducive to sustainable growth.” Fitch Ratings expects an exit vote will have a moderate credit negative impact on its UK rating (AA+/Stable) due to increased risks to “medium-term growth and investment prospects, its external position, and the future of Scotland within it.”
As of year-end 2015, U.S. insurers’ exposure to UK-domiciled debt and equity totaled $118 billion, with $105.4 billion in bonds and $12.6 billion in equities. The bulk of the UK-domiciled debt, approximately 81% of the total, was with nonfinancial corporates. UK bonds represented approximately 15% of the U.S. insurance industry’s foreign bond exposure (approximately $688 billion) at year-end 2015, second only to Canada (16%). Exposure to UK sovereign debt (gilts) was only 1.5% of the UK-domiciled bond exposure, while UK financial bonds were 17%. Exposure to UK equities was the largest foreign stock exposure for the U.S. insurance industry, at 62% of total foreign stock exposure — 3% of which was in UK financial stocks.
The NAIC Capital Markets Bureau will continue to monitor developments relative to the potential Brexit and report as deemed appropriate.
Recent Developments in the Puerto Rican Debt Crisis (05/17/2016)
On May 2, Puerto Rico failed to repay almost $400 million in bonds issued by the Government Development Bank (GDB), Puerto Rico’s main government bond issuer, intergovernmental bank, fiscal agent, and financial advisor. It was the largest missed principal payment so far by the island. The recent default is particularly significant because it means Puerto Rico is now heading towards defaulting on bonds deemed more secure. That is, in Jan. 2016, Puerto Rico defaulted on roughly $37 million in bonds issued under the Puerto Rico Infrastructure Financing Authority (about $36 million) and Puerto Rico Public Finance Corp. (about $1 million), which are considered lower priority bonds by the government as they are not backed by the Puerto Rican constitution. Puerto Rico’s economic crisis has intensified with this most recent missed bond payment because it has been enduring an ongoing economic crisis that seems to have reached a critical stage. Furthermore, if Puerto Rico defaults on its next payment, due July 1, it will have defaulted on approximately $800 million general obligation bonds, which were issued directly by the Puerto Rican government and are protected by the Puerto Rican Municipal Financing Act which states that holders of municipal general obligation bonds shall have the right to compel the municipality to exercise its power to levy taxes for the payment of the principal, interest and premiums of early redemption, if any, of said bonds. While the Puerto Rico debt crisis is not expected to impact the U.S. economy or its $3.7 trillion municipal bond market, a default of this magnitude could lead to years of court proceedings since Puerto Rico currently lacks the ability to file for bankruptcy. The U.S. Congress has been debating whether to grant Puerto Rico the ability to file for bankruptcy. Unless that happens, the only avenue investors will have to resolve their issues will be through the courts.
BACV of U.S. Insurer Exposure to Bonds Issued by Puerto Rico ($)
Par Value of U.S. Insurer Exposure to Bonds Issued by Puerto Rico ($)
Average Book Price of Aggregate Insurer Exposures
As of year-end 2014, direct ownership of Puerto Rican bonds by U.S. insurers was $1.4 billion in book/adjusted carrying value (BACV). As of year-end 2015, it dropped to $1.16 billion, a decrease of 16.7%. Over the same period, the par value of these bonds increased, mostly due to purchases by bond guarantors. Purchases at deep discounts allow the bond guarantors to reduce their net exposure. In addition to the purchases in the last year at deep discounts, the aggregate BACV was also impacted by Other Than Temporary Impairments (OTTI) taken by insurers, reflecting low trading prices and expectations of defaults. From year-end 2014 to year-end 2015 the BACV of property/casualty (P/C) bonds decreased about 6.5% while the par value increased almost 25% (note that bond guarantors file as P/C companies). Recent prices for bonds not benefiting from a guarantee have ranged from $15 to $60, with most trading in the mid-$30s, depending on the specific issuer. U.S. insurance companies’ year-end 2015 exposure consisted primarily of Puerto Rico Sales Tax Financing Corporation (COFINA) bonds, or $788 million BACV representing 67.6% of total U.S. insurer Puerto Rico bond exposure. COFINA bonds are currently trading around $20 to $60. Regulators should consider where insurance companies are valuing bonds issued by Puerto Rico, especially those not insured by one of the bond guarantors.
The Capital Markets Bureau will continue to monitor trends with Puerto Rico’s debt crisis as it evolves.
U.S. Insurance Industry’s YE 2015 Exposure to the Energy Sector: Warrants Continued Monitoring, But No Cause for Immediate Concern (04/26/2016)
At the close of markets on April 22, the price per barrel of West Texas Intermediate crude oil closed at $43.73. This represents a significant improvement from the environment for oil just two months ago, when the contract price traded in the area of $25/barrel, and almost dropped to $20/barrel. Nonetheless, concerns for the energy sector continue. Current prices are still substantially below where they were two years prior, and few market participants expect any substantial improvement in the near term. Bank exposures to weaker drilling companies have gained much attention. These concerns were emphasized in April when Peabody Energy, one of the nation’s largest coal producers, filed for Chapter 11 protection.
Chart 1: Current Contract Price for West Texas Intermediate (6 months)
Reflecting the shifting fortunes of oil prices (as shown in Chart 1), stock prices for energy companies have been equally volatile, falling almost 37% from April 2015 to late January 2016. They have since recovered almost 30%. The U.S. insurance industry’s total common stock exposure to the energy sector was $18.3 billion as of year-end 2015, with the bulk ($15.5 billion) in P/C portfolios. The industry also had about $167.5 billion (81.3%) of aggregate bond exposure to the energy sector with life companies at year-end 2015, followed by $28.9 billion (14.0%) in bonds with P/C companies.
The U.S. insurance industry’s exposure to the energy sector is not insignificant, but it does not warrant major concern at this time. The bulk of the industry’s energy bond exposure (90%) was investment grade, with another 8% in the double-B rating category. A total of $206 billion in energy sector bonds (year-end 2015) was modestly lower than the previously reported $226 billion at the end of 2013, as indicated in a Capital Markets Bureau Special Report published Feb. 27, 2015, titled, “The Current Oil Shock: Modest Impact on Insurance Industry Investment Portfolios.” Roughly 66% of the year-end 2015 exposure was in bonds with maturities of 10 years or less (see Table 1). Exposure to countries whose economies are impacted by volatility in oil prices (i.e., oil-producing countries) has also declined from $169 billion in 2013 to $167 billion in 2014 and $152.4 billion in 2015. In addition, excluding Canada (which had the largest exposure at $33 billion), the largest year-end 2015 investment in an oil-producing country was Mexico at $14.3 billion.
Table 1: NAIC Designations for Energy Sector Bonds by Maturity
||< 1 yr
||1 - 5 yrs
||6 - 10 yrs
||11 - 20 yrs
|NAIC Desig ||< 1 yr
||1 - 5 yrs
||6 - 10 yrs
||11 - 20 yrs
As shown in Table 1, with almost 10% of the U.S. insurance industry’s bond exposure to the energy sector below investment grade, and more than 20% with maturities of more than 20 years, market values will potentially be volatile and warrant continued attention by state insurance regulators. Focusing specifically on below investment grade bonds, the total par value for the industry was $22.8 billion, with a book/ adjusted carrying value (BACV) of $20.8 billion and a reported fair value of $17.2 billion at year-end 2015.
The Capital Markets Bureau will continue to monitor market trends in the energy (and related) sector and report as deemed appropriate.
Year-End 2015 U.S. Insurer Exposure to Private Equity Funds Decreases;
Hedge Funds Increases (04/04/2016)
On March 4, 2016, the NAIC Capital Markets Bureau published a special report on the U.S. insurance
industry's exposure to private equity funds and hedge funds, which included data as of year-end 2014.
The 2015 annual financial statements have now been submitted; while there are likely to be some
continuing updates, significant changes are unlikely. This Hot Spot provides information on exposures
for year-end 2015 and highlights changes since the prior year.
As of year-end 2015, the U.S. insurance industry held approximately $65.5 billion in private equity funds,
a decrease of $4 billion since year-end 2014. Over the same period, hedge fund exposure increased to
$17.7 billion from $16.8 billion. To gain further insight into these exposures, the Capital Markets Bureau
sorted the private equity funds and hedge funds investments held in 2015 by company size (that is,
assets under management, in seven groupings), as shown in Table 1 below.
|2015 Year-End Exposure
|Insurer Groups Based on Asset Size
||Private Equity Funds
|Between $250mm and $500mm
|Between $500mm and $1B
|Between $1B and $2.5B
|Between $2.5B and $5B
|Between $5B and $10B
|Greater than $10B
|Change from 2014
Notably, larger insurers (i.e., those with greater than $5 billion asset under management) generally
reduced their exposure to both private equity funds and hedge funds during the year. (See Table 2.)
Smaller and mid-tier insurer exposures to private equity funds stayed roughly the same. However,
smaller and mid-tier insurers increased their exposures to hedge funds, more than offsetting the
decrease within the larger insurers. Among the group of smaller insurers (i.e., less than $500 million
assets under management), 31 of the 86 companies are new investors in hedge funds. Among the midtier
group of insurers (i.e., between $500 million and $5 billion assets under management), 32 of 135
were insurance companies that reported exposure in 2015, but did not report exposure in 2014.
||Private Equity Funds
As shown in Table 3, in 2015, 89.1% of the industry's exposure to private equity funds was with the
largest insurance companies—that is, those with $10 billion or more assets under management.
Similarly, 62.2% of hedge fund exposure is also within the largest insurers category. There were a total
of 343 U.S. insurance companies with at least some exposure to private equity funds, and 331 with some
exposure to hedge funds.
|Percent of Total PE or Hedge Funds
||Private Equity Funds
|Between $250mm and $500mm
|Between $500mm and $1B
|Between $1B and $2.5B
|Between $2.5B and $5B
|Between $5B and $10B
|Greater than $10B
For both private equity and hedge funds, the exposure among U.S. insurers as a percent of total
invested assets continues to be relatively modest and was 1.2% of total invested assets as of year-end
2015. Table 4 shows U.S. insurer exposure to private equity and hedge funds as a percentage of total
invested assets in 2015.
|Percent of Invested Assets
||Private Equity Funds
|Between $250mm and $500mm
|Between $500mm and $1B
|Between $1B and $2.5B
|Between $2.5B and $5B
|Between $5B and $10B
|Greater than $10B
As noted in the March 2016 special report, performance (in terms of returns) for private equity funds
and hedge funds have, in past years, proven to be less attractive relative to more traditional
investments, and they remain relatively volatile. There are also concerns about transparency and
liquidity. Additional review, especially for smaller and mid-tier insurers, focusing on exposure for
individual companies as a percent of capital and surplus, is warranted.
Negative Interest Rates and Market Implications (02/16/2016)
Recent weeks have seen considerable discussion about negative yields and negative interest rates, not the least of which were comments made by Federal Reserve Chair Janet Yellen. Negative interest rates—or in effect, paying a financial institution to store cash—seems counterintuitive. But, major central banks are using this unconventional tool in their efforts to stimulate economic growth. The expectation is that they will encourage banks to increase lending activity, resulting in more consumer and business spending. In addition, negative interest rates could lead to the devaluation of a country’s currency, making exports more competitive.
In June 2014, the European Central Bank (ECB) cut the deposit rate, or the rate banks receive for funds deposited at the central bank, to negative and lowered it further twice since then. The central banks of other countries—including Japan (most recently in January 2016), Sweden and Switzerland—have also adopted a negative interest rate strategy. On Feb. 10, 2016, in a testimony before the Committee on Financial Services, Yellen was questioned on the possibility of negative interest rates in the U.S., and she commented that the concept is not “off the table” but that further analysis is required to determine its feasibility—legally and structurally. Nevertheless, she said there are no expectations “that the FOMC (Federal Open Market Committee) is going to be soon in the situation where it is necessary to cut rates” given the strengthening labor market and continued moderate expansion in economic activity. However, the market appears to disagree—with the 10-year Treasury yield down 52 basis points (bps) since the beginning of the year to 1.75% as of Feb. 12, 2016—so it will be interesting to see if weakness in either, or both, of these indicators changes Yellen’s view.
Chart 1: Central Bank Policy Interest Rates
As central bank rates serve as a benchmark for borrowing costs, some sovereign bond yields have turned negative—particularly at the shorter end of the yield curve, and in some cases, as far out as six years and even beyond (e.g., Germany, Japan, the Netherlands and Switzerland). Negative yields on market instruments are different from negative rates at central banks. As interest rates have fallen near zero, prices of bonds have traded above par, resulting in their yields becoming negative. In addition, as central banks continue asset purchase programs to stimulate the economy, the additional demand has resulted in even higher bond prices and greater negative yields.
Chart 2: Government Bond Yield Curves
The impact of negative interest rates on the capital markets is akin to an extreme case of low interest rates. Negative yields on government securities lead to even lower yields on investments, putting further pressure on net interest margins and profitability of banks. They could pass through the added costs to their customers, but it would be at the risk of customers withdrawing deposits or losing customers altogether. Since U.S. insurance companies, for the most part, invest in assets that are priced to earn an expected return above a benchmark government rate, a negative yield on the relevant U.S. Treasury rate would result in a lower expected return unless the market-based premium expanded to offset that negative impact. In addition, insurance companies would likely find it challenging to meet long-term liabilities in a negative yield environment—particularly life insurance companies that offer products with fixed rates. Although there has been limited evidence of insurance companies reaching for yield in the past several years, a sustained period of negative yields (after what has already been a lengthy period of low interest rates) could create significant challenges that might encourage them to take on added, and potentially excessive, risks and invest in higher yielding assets at an increasing rate. Negative yields would also significantly affect the money market funds space—a $3.1 trillion market as of Dec. 31, 2015, according to U.S. Securities and Exchange Commission (SEC) data. Money market funds typically invest in highly-rated short-term corporate or government debt for a small return. If these returns turn negative, the business model of money market funds would no longer make sense, and the liquidity and capital preservation they provide would no longer be available to investors.
Although negative yields in the U.S. seems unlikely, the Capital Markets Bureau will continue to monitor developments and trends in the U.S. and global economies and report as deemed appropriate.
Complications for U.S. Insurers Caused by Flatter Yield Curve (02/10/2016)
Market volatility that began at the end of 2015 and increased significantly in the first few weeks of 2016 has led to a number of concerns for investors. More specific to the U.S. insurance industry is the retracing of long-term rates to lower levels, resulting in a flattening of the U.S. Treasury yield curve. In a testimony on Feb. 10, 2016, Federal Reserve Chair Janet Yellen combined a “steady-as-she-goes” account of Fed policy with an acknowledgement of intensifying risks. Virtual zero yields for ten-year government bonds in Japan and Germany that have, on occasion, drifted into negative territory are certain to weigh further on U.S. interest rates.
U.S. Treasury Yields (30-Year, 10-Year and 12-month)
As of February 10th, the differential between the 30-year and 12-month U.S. Treasury yields narrowed to 202 basis points, its thinnest margin in the last five years. Financial institutions in general tend to achieve higher margins with higher interest rates as they typically improve the margin earned on their investment portfolios versus their costs, including payouts to investors, depositors and policyholders. Insurance companies usually benefit from steeper yield curves given their longer-dated liabilities.
Differential between 30-year and 12-month Treasury Yield
Meanwhile credit spreads—as measured generically between investment grade and below-investment grade markets—have shown similar volatility over the last six months. Current levels for investment grade and below-investment grade indices are at the highest levels since the end of 2012.
Benchmark Credit Spreads for Investment Grade and Below‑Investment Grade
Notable is the differential between investment grade and below-investment grade spreads: at 451 basis points, it is the widest margin since the end of 2012. While credit concerns may be applicable to all corporate credits, the wider differential reflects a higher level of concern for weaker, more speculative credits. One driver of wider below-investment grade spreads is the weaker companies in the oil and gas sector. Oil prices, as measured by the West Texas Intermediate benchmark, have dropped more than 70% from their peak in 2011 and more than 50% from their more recent high in 2015. Exposure to below-investment grade investments by U.S. insurers increased slightly in 2014, and while 2015 annual statements have not yet been submitted, below-investment grade exposure is expected to have increased (modestly) again in 2015. Overall, we expect exposure remains modest relative to overall assets and historic peaks.
Differential Between Generic Investment Grade and Below-Investment Grade Spreads
Lower interest rates, particularly long-term interest rates, and a flatter yield curve have presented an investment challenge for U.S. insurers, narrowing the net margin between net portfolio yields and crediting rates. This dynamic moderated somewhat in late 2013 through early 2015, but has returned in recent months. With wider credit spreads on below-investment grade bonds, investors in general are at least getting paid more for taking on the additional risk. However, given the level of volatility in the economy, questions remain as to whether or not it is enough. Reflecting on the increased level of market value volatility, the vast majority of bond investments for U.S. insurers are held at amortized cost. The notable exception is for below-investment grade investments held by companies that do not maintain an Asset Valuation Reserve. This includes mainly property/ casualty companies that increased their exposure to below-investment grade debt from roughly 2% in 2010 to more than 4% based on the most recent reported data.
While U.S. insurers have managed reasonably well through the lower level of interest rates and flatter yield curves in the last five years, albeit with tighter margins and weaker earnings. The renewed market dynamic, along with an increased level of market volatility that will likely cause alternative investments to become less attractive, warrants further regulatory vigilance. The Capital Markets Bureau will continue to monitor these trends and report as deemed appropriate.
Market Update: A Turbulent Start to 2016 (01/19/2016)
The financial markets began 2016 with a bumpy ride, mostly to the downside, as weakness in China's economy, equity and currency markets—along with commodity price declines—continue to spur concerns of a global economic slowdown. The following table provides a snapshot of the performance for select market indicators for 2015 and the first two weeks in 2016.
|Oil - WTI
|10 Yr Treasury
After ending 2015 flat versus 2014, the Standard & Poor’s (S&P) 500 Index (S&P 500) has declined 8.4% to 1871.43 in the first 10 trading days of the year, with significant (or greater than 1%) declines in six of those days. On Jan. 13, the S&P 500 tested its 12-month low of 1867.61 reached on Aug. 25, 2015, after declining 2.5% for the day to close at 1890.28, its steepest decline since September 2015 and resulting in a 7.5% drop since year-end 2014. It then recovered strongly—with the price of crude oil climbing above $31 per barrel and boosting energy shares, a solid earnings report from JPMorgan, and comments from James Bullard of the Federal Reserve easing rate-hike expectations in the U.S.—the following day, increasing 1.7% to 1921.84. With the Shanghai Composite Index closing 3.5% lower and the price of crude oil falling below $30 per barrel on Jan. 15, those gains were erased with the S&P 500 sinking 2.1% to 1880. At this level, the U.S. equity market is 11.8% below the high reached in May 2015—resulting in the market being in a “correction,” or a decline of 10% or more from a recent peak. As investors sought safety in high-quality investments, the 10-year Treasury rallied to a yield of 2.03%.
The credit markets are also feeling pressure, with both investment grade and high-yield credit experiencing significantly wider spreads. From a March 5, 2015, tightest credit spread point of 60 basis points (bps), the Markit CDX Investment Grade (IG) Index reached its widest spread for the prior 12-month period of 110 bps on Jan. 15. High-yield credit spreads also widened to their highest spread in the period of 555 bps the same day, after trading in a range of 299 bps to 523 bps in 2015. Although credit spreads have widened significantly, they have, in part, retraced the tightening seen in early 2015; however, evidence of credit deterioration is beginning to materialize. According to S&P Ratings Services, the number of global corporate ratings on negative outlook relative to positive outlook at Dec. 31, 2015, was at its highest level since June 2010. In addition, it said “global creditworthiness has declined slightly
since the onset of the [global financial] crisis” with the “average long-term corporate credit rating [falling] by about half a notch to between ‘BB+’ and ‘BB’ compared with ‘BB+’ at end-2008.” S&P estimates that the U.S. trailing 12-month speculative grade corporate default rate was 2.8% in December 2015, the highest level since 2012. It expects the rate to rise to 3.3% by Sept. 30, given persistently low oil prices, slower global growth and the beginning of interest rate hikes by the Federal Reserve.
As of Dec. 31, 2014, the U.S. insurance industry held common stock investments and corporate bond investments totaling $684 billion (or 11.9% of total invested assets)—including affiliated holdings—and $2.1 trillion (or 35.8% of total invested assets), respectively. P/C insurers’ exposure to common stocks was $497 billion (or 28.5% of total invested assets), whereas life companies’ exposure was $149 billion (or 4% of total invested assets). However, because insurers’ aggregate exposure to common stock is relatively modest compared to other assets such as bonds, the expected impact of a significant stock market sell-off on their capital and surplus is limited. Nonetheless, the common stock exposure of individual insurance companies relative to total capital and surplus, in particular for P/C insurers, can vary greatly and should be monitored closely. Life insurers typically have significantly more exposure to corporate bonds (61% of year-end 2014 bond investments) than P/C companies (34% of year-end 2014 bond investments). Despite the material exposure to corporate bonds, almost 95% of the holdings were investment grade. Because their exposure to high-yield bonds is relatively small, adverse developments in high-yield credit should only affect insurers at the margin, unless those developments spill over into the broader corporate market.
Equity Markets’ Volatility and U.S. Insurance Industry Exposure (9/02/2015)
Stocks around the world continued to be volatile as September began, on the heels of their worst month in more than three years. Driving the sell-off were continuing concerns that China’s slowdown will weigh on the global economy, along with investor uncertainty with regard to the timing and magnitude of an anticipated increase in interest rates by the Federal Reserve. Coming off a steep decline in August, the Standard & Poor’s (S&P) 500 Index fell 2.96% to 1,913.85 on Sept. 1, the third-worst drop this year, possibly setting a sour tone for September — historically the worst month of the year, in which the index has fallen 1.1% on average going back to 1927 — although stocks staged a partial rebound in the following session. Equities in Asia also were volatile, as the Shanghai Composite index dropped nearly 5% intraday after manufacturing reports pointed to a deepening Chinese economic slowdown, but then recovered on news of additional government intervention.
Table 1 shows the recent performance of major stock markets around the world, as measured by benchmark indices. The data show that all major markets are in a so-called correction, typically defined as a decline of 10% or more from their prior peak, except the U.S., which has been wavering near the edge of correction territory. Further, the data show that stocks in Hong Kong and mainland China are down 26% and 39%, respectively, from their prior peaks, signifying bear markets (typically a 20% or greater decline).
|World Stock Market Indices' Performance as of Sept. 2, 2015
|S&P TSX Composite(Can.)
|Financial Times 100(U.K.)
|Euro Stoxx 600(Eur.)
|Hang Seng Index(H.K.)
Because most U.S. insurers’ common stock holdings are U.S.-based, it is reasonable to estimate the potential mark-to-market impact of the stock market decline on U.S. insurers’ capital and surplus using the 12.5% peak-to-trough decline in the S&P 500 Index. Table 2 shows the unaffiliated common stock exposure of U.S. insurers in relation to their total capital and surplus as of year-end 2014 and as of June 30, 2015. It also shows the hypothetical percentage impact on capital and surplus of the decline in stocks from their peak to the August market trough. Because insurers’ aggregate exposure to common stocks is relatively modest compared to other assets such as bonds, the expected impact of a significant stock market sell-off on insurers’ capital and surplus is modest, even in the case of property/casualty (P/C) insurers, which are the most heavily exposed to stocks. The common stock exposure of individual insurance companies relative to total capital and surplus varies greatly, however, depending on investment allocations and capital structure; it significantly exceeds total capital and surplus in a relatively small number of cases.
|U.S. Insurers' Common Stock Exposure Relative to Total Capital and Surplus
|U.S. $ mil., as of 12/31/14
|Unaffiliated Common Stock
|Total Capital and Surplus
|Unaffiliated Common Stock as Percentage of Total Capital and Surplus
|U.S. $ mil., as of 6/30/15
|Unaffiliated Common Stock
|Total Capital and Surplus
|Unaffiliated Common Stock as Percentage of Total Capital and Surplus
|Estimated Mark-to-Market Impact on Total Capital and Surplus of a 12.5% Decline in Market Value of Unaffiliated Common Stock
|Greece and Puerto Rico Turmoil – Minimal Impact on U.S. Insurer Investments (6/29/2015)
Over the weekend, two announcements were released with negative implications relative to sovereign and municipal debt: one pertaining to Greece and the other Puerto Rico. While neither topic is new to the capital markets, both news releases were significant in that they carry negative implications in the ongoing turmoil within each area of focus.
After the Greek government’s negotiations with creditors came to an impasse, it announced that Greek banks would close for six days and impose capital controls for the next week, until a national referendum scheduled to take place on July 5th. The referendum will determine whether the Greek government will accept austerity measures demanded by the country’s creditors in exchange for additional aid. Furthermore, on Sunday, June 28, the European Central Bank froze emergency loans to Greek banks at their current level of €89 billion, and Athens is expected to default on a €1.55 billion (USD 1.73 billion) payment due to the International Monetary Fund, as it has lost international rescue loans for the first time in more than five years. The U.S. insurance industry’s year-end 2014 exposure to Greece was modest, at $117.3 million ($7.3 million in bonds and $100 million in equities), with only $0.2 million in Greek sovereign debt. The exposure had been larger until 2011, at just over $1 billion, when the Greek government restructured significant portions of its debt, exchanging old bonds for newer ones at about 25 cents on the dollar. Greece’s long-term sovereign debt rating is currently CCC/Caa3/CCC by Standard & Poor’s (S&P), Moody’s Investors Service (Moody’s) and Fitch Ratings, respectively.
Besides direct Greek sovereign exposure, there is also potential concern for secondary impacts. Exposure to banks, especially European banks that are exposed to Greek sovereign debt, is one example. The total bond exposure of U.S. insurers to European banks was not substantial, at approximately $6.8 billion as of year-end 2014. The largest three exposures to non-U.S. banks were with Credit Suisse, HSBC Holdings PLC, and Deutsche Bank. In addition to direct investments in these aforementioned banks, U.S. insurers may also have some exposure to those banks as counterparties in derivatives transactions. The three largest European bank exposures based on notional value include Deutsche Bank, Credit Suisse and Barclays, however, the actual exposure to these banks is much smaller (i.e. due in part to netting, etc.), and should be well-collateralized.
The governor of Puerto Rico also announced over the weekend that the commonwealth’s debt is unpayable. At $72 billion, Puerto Rico’s debt load represents more than 70% of GDP. The island’s economy has been suffering since 2006 with the closure of U.S. military bases, followed by the elimination of tax incentives that caused pharmaceutical companies and other manufacturers to leave. The resulting problem with unemployment (currently at 12%) has led the country’s younger population to immigrate to the U.S. mainland, further shrinking the country’s tax base and in turn exacerbating the situation. Puerto Rico’s population has fallen 4.7% since 2010. Puerto Rico’s municipal bonds had been considered attractive because they are exempt from federal, state and local income taxes in the U.S. The largest holders of Puerto Rico’s bonds are municipal bond mutual funds. Direct ownership of bonds by U.S. insurers was $1.4 billion as of year-end 2014. In addition, bond guarantors are estimated to have exposure of approximately $14 billion in par value of bonds. In general, U.S. insurer exposure to Puerto Rican bonds has been declining as the commonwealth’s financial struggles have increased. The long-term debt ratings on the Commonwealth of Puerto Rico are currently CCC+/Caa2 by S&P and Moody’s, respectively.
Moody's Lowering City of Chicago Debt Rating to 'Junk' Status Has Small Impact on Overall Insurance Industry Holdings (5/15/2015)
Moody's Investors Service (Moody's) on May 12 lowered the credit rating on the city of Chicago's $8.1 billion outstanding general obligation (GO) bonds to Ba1 from Baa2, along with the credit ratings on approximately $800 million tax revenue debt and authorized motor fuel tax revenue debt. The downgrade is a consequence of a ruling by the Illinois Supreme Court last week that limited Chicago and the state of Illinois' ability to handle unfunded pension plans. It also includes Moody's expectation that the city's elevated unfunded pension liabilities will continue to grow.
In addition, according to Moody's, "The Ba1 rating on the sales tax and motor fuel tax debt reflects the absence of legal segregation of pledged revenue from the general operations of the city. This lack of separating caps the ratings at the city's GO rating." Moody's has also kept a negative outlook on the revised rating. Moody's currently has a long-term rating of A3 on the state of Illinois with a negative outlook.
Notwithstanding, Standard & Poor's (S&P) and Fitch Ratings (Fitch) both maintain an investment grade rating on Chicago's GO bonds. S&P on May 14 lowered Chicago's GO bond ratings to A- from A+ and placed the ratings on CreditWatch with negative implications. According to S&P, the rating action reflects the city's short-term liquidity pressures. S&P also warned that it could lower Chicago's long-term GO debt rating further "if the city does need to access its own internal liquidity at levels we feel compromise its overall liquidity strength." Fitch has an A- credit rating assigned to Chicago's GO bonds, with a negative outlook.
As of year-end 2014, the U.S. insurance industry had approximately $7.2 billion in Chicago municipal debt outstanding (not including the exposure of financial guarantors), a large proportion of which was held by property/casualty (P/C) companies. In the event S&P or Fitch lowers the rating on Chicago's GO bonds to below investment grade, the result would be an NAIC Designation below NAIC 2. In turn, P/C and health insurers would have to hold these bonds at the lower of cost or fair value. Given the relatively small exposure of Chicago municipal debt compared to the industry's approximate $5.5 trillion in total invested assets, this exposure does not result in significant cause for concern. However, individual company exposures may be significant as a percent of capital and surplus.
Implications of Currency Policy Change by Swiss National Bank (1/29/2015)
On Thursday, Jan. 15, the Swiss National Bank announced an end to the Swiss currency peg of $1.20 to the euro, a policy adopted in September 2011. The policy change was prompted by the continued devaluation of the euro due to anemic to negative economic growth in the region. On Thursday, Jan. 22, 2014, the European Central Bank (ECB) announced a €60 billion per month government bond purchasing program in hopes of stimulating growth in the Eurozone. The stimulus program would push up government bond prices, thus making it more expensive for the Swiss National Bank to continue the $1.20 peg policy.
Following the announcement of an end to the peg policy, the Swiss franc jumped about 18%. The currency increase benefits some but not others. Anyone receiving francs are beneficiaries because of the increased value. In global trade, Swiss exporters do not benefit, as their products are now more expensive relative to other currencies.
As of year-end 2013, U.S. insurers reported total holdings of about $9.4 billion in book/adjusted carrying value (BACV) of securities issued by companies domiciled in Switzerland. The $9.4 billion in BACV consisted of about $6.7 billion in bonds and $2.7 billion in stock. About $158 million of the bond holdings, or less than 2.5%, was denominated in Swiss francs. About 97% of the total Swiss bond exposure was allocated to corporate bonds. Based on the direct exposure of $158 million to the Swiss franc relative to total cash and invested assets of about $5.5 trillion, there is no major direct risk to U.S. insurers.
Due to the rising Swiss franc, Credit Suisse, whose U.S. subsidiaries were counterparties for $113 billion in notional value of derivatives transactions with U.S. insurers, announced it expects a drop in profits for the first three quarters of 2014, but the company suffered no “material trading losses” from the rise in value. Other large multinational corporations are expected to experience a similar strain on profits. The contagion will affect companies outside of the financial sector, including (among others) Glencore International (commodities), Nestlé (food and beverage) and Novartis (pharmaceuticals). In addition, U.S. companies, including insurers, engaged in derivatives transactions may face increased counterparty risk as a result. Collateral posting, a standard requirement in derivatives transactions, should offset the counterparty risk. Approximately 127 U.S. insurers have Swiss-domiciled corporate parents. Given the negative pressure on earnings and profits, a Swiss parent company is incented to take possession of U.S. dollar-denominated assets held by subsidiaries. Another concern is that earnings not denominated in Swiss francs are now worth less, creating a desire, or need, to increase dividends to offset the currency valuation loss. Such an action by a U.S. insurer’s Swiss parent may jeopardize the capital position of the insurer.
The NAIC Capital Markets Bureau will continue to monitor trends in the Swiss franc and report as deemed appropriate.
Recent Economic Trends and Volatility in Major Foreign Currencies (1/13/2015)
As the euro area economy continues to struggle, growth in China begins to slow, and oil prices(per the West Texas Intermediate, WTI) dipped to their lowest intraday level of $46.83 a barrel on Jan. 7, 2015(since April 2009), certain foreign currencies –particularly the euro, the Canadian dollar (loonie) and the yen– have experienced significant declines.
The U.S. insurance industy’s direct exposure to foreign currency risk remains modest. As of year-end 2013, translated into U.S. dollars, the U.S. insurance industry had approximately $47.7 billion in foreign currency exposure, of which the largest five currency exposures were: $21 billion in Canadian dollars, $10 billion in Japanese yen, $8 billion in the euro, $5.5 billion in the British pound and $1.6 billion in Australian dollars. In Canada, unemployment was an unexpected 6.6% in December 2014, which was also the second straight month of job losses for the country, suggesting its economic progress is flailing. The loonie has dropped 12.1% since mid-June 2014, reaching its lowest level in January 2015 (since May 2009). The Japanese yen decreased 12% in all of 2014, and despite some upticks and the Bank of Japan stating it will buy at least 1.25 trillion yen, the value of the yen is expected to continue to decrease in 2015; it has been on a declining trend for three years. The value of the yen dropped 17% from early July 2014 to early January 2015. A weak economy persists in the euro area, with poor industrial data reported from three large Eurozone economies (Germany, France and Finland) suggesting recovery is far off and faltering. Political uncertainty (particularly related to the upcoming Jan. 25 Greek elections) and deflation risk further put economic recovery at risk in this area; however, additional economic stimulus by the European Central Bank may be on the horizon in the form of sovereign bond purchases (in particular, €500 billion of investment-grade assets). On Jan. 8, 2015 the euro reached its lowest level since December 2005, down 15% from May 2014. Lastly, the value of the Australian dollar and British pound also experienced relatively large decreases from July 2014 to early January 2015, at 14.1% and 11.8%, respectively.
The NAIC Capital Markets Bureau will continue to monitor trends with foreign currencies in general and report as deemed appropriate.
U.S. Insurance Industry Investment Exposure to the Energy Sector and Oil-Exporting Countries is Modest as Oil Price Plunge Continues (12/17/14)
Bloomberg News reported on Dec. 16 that the global price of crude oil plunged through $60 a barrel for the first time in five years. New York-traded West Texas Intermediate, the world's most liquid forum for crude oil trading, dipped below $55 on Dec. 16 for the first time in five years. From its mid-June peak, crude oil has slumped nearly 50% through mid-December this year. The stocks and debt securities of oil-producing companies are coming under pressure—high-yield exploration and production and oil-service companies in particular—while oil-exporting countries such as Russia (where the ruble has declined precipitously to record lows), Nigeria, Iran and Venezuela have also been hard-hit.
Figure 1: Price of Crude Oil (WTI), Last 30 Years
Energy stocks have come under pressure: The S&P 500 Energy Index is down about 10% over the past 12 months, despite the broad index’s 14% positive 12-month return. Energy sector high-yield corporate bonds have also sold off. As of Dec. 16, the Energy component of the Markit CDX HY CDS Index had widened to 676 basis points (bps) after ranging from 250 bps to 300 bps for most of the year, while the overall CDX HY index widened to 404 bps after trading between 300 bps and 350 bps for most of 2014. Due to investor fear of “contagion,” ripples have spread, causing emerging markets around the world to sell off. Through mid-December, stock markets in Colombia, Brazil, Mexico and Chile are down 13% to 30% in the past 12 months on a currency-adjusted basis, and Russia’s MICEX Index is down 52%. Emerging market debt has followed suit, as the emerging market CDX Index widened to 419 bps on Dec. 16 after trading between 250 bps and 350 bps for most of the year.
At present, the global demand for oil is low because of weak economic activity, as well as increased energy efficiency, and a steady shift away from oil to alternative energy sources. Despite ongoing economic recovery in the U.S., economic activity in Europe remains sluggish. In addition, Asian economic growth remains under pressure, with Japan stagnant and China’s growth continuing to decelerate. On the supply front, geopolitical tensions have not disrupted oil, and the market seems relatively unconcerned about geopolitical risk. At the same time, the shale oil boom in the U.S. has enabled it to become the world’s largest oil producer. This has allowed the U.S. to sharply reduce its dependence on imports, thereby freeing up global supply. OPEC, led by Saudi Arabia and other Gulf countries, has maintained production levels to preserve market share. According to The Economist magazine, Saudi Arabia can easily handle lower oil prices, given its $900 billion of reserves and its ultra-low production cost ($5 to $6 per barrel).
The fallout from the oil price plunge is worst for the players in the industry who have high cost structures (i.e., deep-water or Arctic drilling) that make them the most vulnerable to lower prices. The hardest hit countries are those dependent on a high oil price to fund their fiscal imbalances. The two most prominent countries are Russia (already suffering due to Western sanctions following its annexation of Crimea and continued interference in Ukraine) and Iran (which is supporting the Assad regime in Syria). The Russian ruble has plummeted more than 50% through mid-December despite massive efforts by the Russian central bank (an 11.5 percentage-point increase in rates and more than $80 billion of intervention), igniting market fears that capital controls may be imminent. The latest 6.5 percentage-point rate hike was the largest since the 1998 Russian sovereign default.
As of year-end 2013, the U.S. insurance industry had modest exposure to the key oil-exporting countries around the world, with a combined $169 billion of debt and equity exposure, or 3.0% of total cash and invested assets. Drilling down to specific country exposures, the majority, or 78%, was to Canada, whereas exposure to Russia and Venezuela was $882 million and $1.6 billion, respectively. There was minimal to no exposure to Iran or Nigeria. The U.S. insurance industry’s worldwide oil-and-gas-related bond and stock exposure totaled $226 billion, or 4.1% of total cash and invested assets. Note that the country exposures and the energy sector exposure are not mutually exclusive.
The NAIC Capital Markets Bureau will continue to monitor events within the energy sector and the regions affected and will report as deemed appropriate regarding any potential impacts to the U.S. insurance industry’s investments.
U.S. Insurance Industry Exposure to Argentine Sovereign Debt is Small as Default is Possible (7/30/14)
Argentina is at risk of defaulting on interest payments due today, July 30, on $13 billion in sovereign debt maturing in 2033. The default is expected to occur because of a ruling by the U.S. District Court, which blocked the country’s attempt to transfer $539 million in interest on the 2033 bonds to investors because it did not set aside amounts owed to “holdout” creditors related to Argentina’s previous 2001 debt default.
Argentina, the third-largest Latin American economy, last defaulted on $95 billion in sovereign debt in 2001, most of which was swapped for new bonds in 2005 and 2010. Investors took a 70% loss on the principal, but 7% of the holders (the “holdout” creditors, or hedge funds) rejected the restructuring terms and won a U.S. District Court ruling to reclaim 100% of all principal and unpaid interest. July 30 is the last day of a 30-day grace period for Argentina to pay interest due on the 2033 bonds. Based on default provisions in the bond indenture, a default on the interest payments could trigger a cross-default clause that allows other investors to demand return of the principal and unpaid interest immediately (provided, however, that holders of at least 25% of the debt demanded their money returned).
Argentine government officials and the holdout creditors are in talks today aimed at avoiding default, which could occur if Argentine President Cristina Fernández de Kirchner either agreed to settle the suit filed by the creditors, compensate them in full, or obtain a delay on the U.S. court ruling that prohibits Argentina from servicing the 2033 debt before paying the holdout creditors.
As of July 29, and according to Bloomberg, the bonds due in 2033 were trading at 82% of par, which was above their 74% of par average for the past five years. The morning of July 30, the bonds were trading at 92.2% of par. In addition, average yields on Argentine debt were 9.7% as of July 28.
As of year-end 2013, the U.S. insurance industry had a modest exposure to Argentine debt, at $172 million, 73% of which was sovereign debt. Within this sovereign debt exposure, approximately $56 million was in the bonds maturing in 2033. In addition, the industry had approximately $15 million in exposure to Argentine equities. The long-term sovereign debt ratings for Argentina are currently CCC-/Caa1/CC by Standard & Poor’s, Moody’s Investors Service and Fitch Ratings, respectively.
The NAIC Capital Markets Bureau will continue to monitor events within this region and report as deemed appropriate regarding any potential impacts to the U.S. insurance industry’s investments.
U.S. Insurance Industry Exposure to Ukraine is Minimal, Mitigating Concern Over Prime Minister Departure and Continued Political Uncertainty (7/25/14)
The crisis in Ukraine continues, with the most recent news of Prime Minister Arseniy Yatsenyuk’s resignation on July 24, triggered by dissolution of Ukraine’s ruling coalition. Yatseynuk’s resignation must be approved by parliament according to Ukraine’s constitution. In the meantime, the existing cabinet remains in place until a new coalition is formed, likely after elections that are expected to occur in late October.
Yatsenyuk’s administration commenced in Ukraine in February 2014 after street protests caused former President Viktor Yanukovych to flee. Since then, the eastern part of Ukraine has fought a pro-Russian rebellion that is believed to be supported by the government in Moscow. Remember that, in March, Crimea, the former Ukrainian peninsula, was annexed by Russia. Yatsenyuk is credited with leading Ukraine’s economy during the crisis, implementing tough measures that resulted in the country receiving a $17 billion loan from the International Monetary Fund (IMF). To qualify for the next loan tranche from the IMF, Ukraine is expected to implement social spending cuts and army spending increases.
The yield on the 10-year Ukrainian U.S. dollar-denominated bond has been extremely volatile, ranging from 8.1% on July 23 to more than 11.0% in February 2014. After reaching a year-to-date low on July 23, the yield on the sovereign bond widened approximately 15 basis points to 8.2% on the news of the Ukrainian premier’s resignation. These yields equate to prices ranging from $96 to $79, with the current price at $95.
According to Bloomberg data, the Ukrainian hryvnia has depreciated almost 30% against the U.S. dollar since the beginning of 2014 and remained relatively unchanged at 11.7 per dollar on the news.
As of year-end 2013, the U.S. insurance industry had a modest exposure of $85.2 million in Ukrainian bonds, $70.5 million of which was in sovereign debt. Ukrainian U.S. dollar-denominated long-term sovereign debt is rated CCC/Caa3/CCC by Standard & Poor’s, Moody’s Investors Service and Fitch Ratings, respectively. Other former USSR exposures include an aggregate of approximately $667 million with Georgia, Kazakhstan, Latvia, Lithuania and Slovenia as of year-end 2013. Despite the small exposure, the situation bears close monitoring until a resolution is reached, which is not expected to occur anytime soon. Further volatility is expected, as is economic and financial damage with the continued hostility between Ukraine and Russia.
The NAIC Capital Markets Bureau will continue to monitor events within this region and report as deemed appropriate regarding any potential impacts to the U.S. insurance industry’s investments.
U.S. Insurance Industry Exposure to Thailand is Minimal, Mitigating Concern Over Military Coup (5/23/14)
The ouster of the civilian leaders of Thailand and seizing of government control by military leaders could potentially increase the market risk of related investments in the portfolios of U.S. insurers. The potential risk is mitigated by the small concentration of Thai securities held by insurers.
As of the 12 months ended May 23, 2014, the Thai baht depreciated 9.17% against the U.S. dollar. The price stood at 32.6. On Jan. 6, 2014, it reached a high of 33.08. The yield on the 10-year Thai U.S. dollar-denominated bond has experienced some volatility over the past three months, ranging from approximately 3.37% to more than 3.78%. On May 23, 2014, the ask price on the 10-year Thai bond was 107.68 and the bid was 105.88. Thai government credit-default swaps (CDS) reached almost 180 in early 2014, indicating a market-perceived increase in risk. The CDS have since fallen to a May 23, 2014, close of 138.8.
As of year-end 2013, the U.S. insurance industry had a total exposure of $478 million in book/adjusted carrying value (BACV) in Thai securities, of which 98% were in bonds and 2% in equity. Life insurers had the greatest exposure to Thai bonds at $418 million, representing about 89% of the bond exposure. About 60% (or $281.8 million) of the energy sector investments were in PTT PCL (BBB+, Standard & Poor's) and 16% (or $76.3 million) of the financial sector investments were in Bangkok Bank (Baa1, Moody's Investors Service). P/C insurers had the greatest exposure to equities at $9.6 million (or about 88%) of the equity exposure.
Table 1: Sector Breakdown of Bond Investments (BACV)
Table 2: Sector Breakdown of Equity Investments (BACV)
Thai U.S. dollar-denominated long-term sovereign debt is rated A-/Baa1/A- by Standard & Poor's, Moody's Investors Service and Fitch Ratings, respectively. While this exposure is small, the situation bears closer monitoring until a resolution is reached.
The NAIC Capital Markets Bureau will continue to monitor events within this region and report as deemed appropriate regarding any potential impacts to the U.S. insurance industry's investments.
U.S. Insurance Industry Exposure to Ukraine and Former USSR Countries is Minimal, Mitigating Concern Over Political Uncertainty (3/5/14)
The current crisis in the Ukraine, particularly the recent intervention by Russian militia in Crimea, has triggered volatility in global financial markets, including stock losses in the U.S., Europe and Asia. U.S. Treasuries, however, have rallied because of investors' flight-to-quality instinct. While the Russian economy has been struggling, it could benefit from the current turmoil in the form of higher prices for oil and gas, two of its main exports.
Recently, the Russian ruble has dropped to a record low against the dollar and the euro, and Russian stocks have decreased by 10% since the beginning of the year. In addition, the yield on the 10-year Ukrainian U.S. dollar-denominated bond has been extremely volatile, ranging from approximately 9.0% to more than 11.0% in February 2014, closing on March 4 at 9.5%. This equates to prices ranging from $80 to $91, with the current price at $88.50.
According to JPMorgan Asset Management, the Ukraine desperately needs financial support — a situation that existed prior to the current turmoil. While the Ukraine‘s current interim government has been negotiating with the International Monetary Fund (IMF) about a bailout agreement, its foreign reserves have dropped to record lows along with its currency, the hryvina. That said, the possibility of a Ukrainian sovereign default cannot be ruled out. And the market price of insuring against Ukrainian default has increased 300 basis points since the summer of 2013.
As of year-end 2012, the U.S. insurance industry had a modest exposure of $94 million in Ukrainian bonds, of which 84% was in the form of government bonds. There were no Ukrainian equity investments. Taking a broader view, exposure to all of the former Union of Soviet Socialist Republics (USSR) totaled $1.6 billion in book/adjusted carrying value (BACV). The majority of former USSR exposure was with Russia at $1.1 billion, the majority of which (72%) was also sovereign debt.
Ukrainian U.S. dollar-denominated long-term sovereign debt is rated CCC/Caa2/CCC by Standard & Poor‘s, Moody‘s Investors Service and Fitch Ratings, respectively. Russian U.S. dollar-denominated long-term sovereign debt is rated BBB/Baa1/BBB by the three aforementioned nationally recognized statistical rating organizations. Other former USSR exposures included an aggregate of $410 million with Georgia, Kazakhstan, Latvia, Lithuania and Slovenia. While this exposure is small, the situation bears closer monitoring by regulators until a resolution is reached. Further volatility is expected, as is economic and financial damage if there is a continued
standoff between the Ukraine and Russia.
The NAIC Capital Markets Bureau will continue to monitor events within this region and report as deemed appropriate regarding any potential impacts to the U.S. insurance industry‘s investments.
Leveraged Bank Loans: Increased Demand, Deteriorating Underwriting and Revised Regulatory Guidance (4/2/2013)
New issuance of leveraged bank loans has been increasing post-financial crisis, including among nontraditional lenders. Consequently, bank regulators are concerned over the quality of these loans due to signs of weakening standards. To the extent insurers consider investing in leveraged bank loans either directly or through collateralized loan obligations (CLOs) — particularly in this current low interest rate environment — thorough analysis, including a review of appropriate documents and models associated with the investment, will identify the risks involved and whether the proposed investment is prudent based on the insurer's strategy and investment guidelines. Having the appropriate infrastructure within an insurer's portfolio management division can help identify and monitor these risks. This includes having experienced analytical professionals within the portfolio management and credit analysis team, in addition to appropriate systems and monitoring processes in place with respect to operations and administration (as well as for business continuity plans). In addition, how the bank loans are sourced and the insurers' relationships with traders or agent banks, along with whether the bank loans are first or second lien, and how they are priced (i.e., marked-to-market, and by which vendor(s)) are also factors to be considered by insurers when investing directly in bank loans. Note that with respect to syndicated bank loans, the lead agent bank usually has (limited) authority to act on behalf of the syndicate regarding any amendments to the bank loan terms. This, therefore, emphasizes the need for insurers, and all investors for that matter, to understand the nature of their investments.
Leveraged bank loans are attractive in the current low interest rate environment because they are high-yielding with floating interest rates that increase as rates rise. Though they are typically rated below investment grade by the rating agencies, they are also senior debt within a company's capital structure, meaning that they take priority with respect to interest and principal over other classes of company debt. According to Standard &Poor's, the average yield on a leveraged loan was 5.44% in January 2013 compared to 2.75% on an investment grade corporate bond (according to Barclays U.S. Corporate Index). Leveraged loan issuance for all of 2012 was $42 billion, compared to a high of $160 billion in 2007, according to S&P Capital IQ Leveraged Commentary and Data.
In addition to a primary market for new issuance, there is an increasingly liquid secondary market for investing in leveraged bank loans, which has attracted additional institutional investors. Insurance companies invest in bank loans; however, historically, direct exposure has been minimal. Insurers are exposed to bank loans indirectly through investments in CLOs, which were approximately $22 billion as of year-end 2011. A resurgence of new issuance in CLOs post-financial crisis has played a role in the increased demand for leveraged loans.
Leveraged lending decreased during the financial crisis but has been on a rebound since 2009. Non-bank lenders, as well as non-regulated investors, entered the market and were willing to accept looser bank loan terms. Consequently, underwriting standards have deteriorated; for example, meaningful maintenance covenants were being excluded. These "covenant-lite" loans do not have the safeguards — such as limits on how much debt a company can add to its balance sheet — that traditional leveraged bank loans carry. According to S&P, for the first two months of 2013, $25 billion of covenant-lite loans were issued, which is almost the same amount that had been issued at their peak in February 2007.
On March 21, banking regulators (that is, a joint effort between the Federal Reserve Board, The Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency) released updated supervisory guidance for banks regarding leveraged lending due to concerns over looser underwriting standards and banks increasing risk. The revised guidance primarily focuses on having banks establish sound risk-management practices; underwriting standards with clearly defined expectations; valuation standards that include established policies and procedures; pipeline management such that exposure can be measured timely; and reporting and analytics that include appropriate management information systems for monitoring loan characteristics and to perform stress testing.
Consequently, the Capital Markets Bureau believes it is important for state insurance regulators to be aware of the potential risks that bank loans as investments might carry, particularly if they reach high concentrations, and to be alert for significant investments by any one insurer.
Reaching for Yield with Structured or Esoteric Investments (8/7/2012)
In the current environment of a relatively flat yield curve and low interest rates — and with the expectation that low interest rates will persist at least through late 2014 — investors in general and insurance companies specifically may seek investing in assets that generate a higher yield than the more traditional, "plain vanilla" investments, such as corporate bonds or U.S. Treasuries. Alternatives that would add incremental yield, though sometimes only nominal, would be structured or esoteric investments. The concern with a structured or esoteric investment is not necessarily that the probability of default would be higher than that of a more traditional investment, but rather, that other key factors — such as loss given default, predictability of income streams, market value volatility, liquidity and counterparty risk — could negatively impact the investment and, therefore, the overall investment portfolio.
For example, in the case of residential mortgage-backed securities and commercial mortgage-backed securities, recent Capital Markets Special Reports have highlighted that some structures have significantly higher downside volatility in more conservative loss scenarios than the majority of the insurance industry's holdings. In addition, income streams might fluctuate dramatically for leveraged interest rate products; that is, bonds whose coupon is not only dependent on the performance of an economic or market variable such as the Consumer Price Index, the London Interbank Offered Rate (LIBOR) or the Standard & Poor's 500 Index, but which can also be leveraged to exaggerate volatility. In some structures, if the economic or market variable does not meet a specified target, no interest payment is due. So, although the repayment of principal is not directly affected, the income stream of the bond can vary dramatically from one period to another. Finally, with synthetic structured securities — which are created through a credit default swap or other derivative whereby the synthetic aspect allows the investor access to investments that might not otherwise be available — investors might incorrectly identify the investments' relevant risks, including counterparty risk, because of the complex structure of these investments. The complexity of the cash flows of some of these structures can often make it difficult for investors to fully understand the drivers behind cash flows. Synthetic structured securities, which include credit-linked and different kinds of equity-linked securities, have existed for quite some time but tend to be much more prevalent when there is limited new issuance.
Aside from the concerns discussed above, the market for highly structured and esoteric investments is not necessarily liquid. That is, they are not traded frequently, and their market prices are not always readily available. These investments, therefore, cannot be relied upon to support unexpected, short-term cash flow needs that would require the immediate sale of the securities. Although there does not appear to be significant exposure in the insurance industry of these securities, there is considerable discussion in the marketplace about developments in these areas. Therefore, the Capital Markets Bureau believes it is important for state insurance regulators to be aware of the potential risks that these types of investments might carry, particularly in high concentrations, and to be alert for significant investments by any one insurer.
Implications of Potential Ratings Downgrades to Banks as Counterparties (5/10/2012)
Given the continued volatility in the Eurozone, European banks have been downgraded in recent months and are at risk for additional downgrades by one or more of the nationally recognized statistical rating organizations (NRSROs). U.S. bank ratings have also been lowered, or are at risk of downgrade, due in part to the impact of a weak global economy on their earnings prospects, as well as their exposure to the sovereign debt of Eurozone countries. In addition to the fundamental issues related to their core banking operations, the lower ratings could force banks to post additional collateral or possibly face the unwind of related derivatives transactions.
The latter could also impact insurers with respect to their derivatives exposure. Certain state laws require that derivative counterparties (i.e., banks) maintain a minimum credit rating. That is, insurers are not permitted to enter and have exposure to derivative transactions with counterparties that do not meet a minimum rating threshold. Upon the downgrade of a counterparty's rating below the minimum threshold, to be in compliance with applicable state laws, the insurer may be required to terminate, or unwind, any derivative transaction with the counterparty or request a waiver for the said requirement from the regulator. A forced unwind would result in the insurer having to replace the counterparty with one that is "approved" by applicable state law in terms of minimum rating requirement, among other factors, or abandon the derivative transaction altogether, either of which could be costly. Given that approximately 90% of the insurance industry's derivative transactions are used for hedging purposes, there are additional implications from a risk-management standpoint.
Therefore, the states should be cognizant of their applicable derivatives use laws and the potential impact of bank ratings downgrades. In addition, other bank-related investments that might be linked to ratings or have minimum counterparty ratings requirements, such as letters of credit, might also be impacted by the potential for lower bank ratings. The NAIC Capital Markets Bureau will continue to monitor any related trends pertaining to this topic.
Liquidity Swaps: Potentially Increasing Interconnectedness between Insurance and Banking (2/24/2012)
Given the current environment in Europe, and as a means to ensure access to funding, some European banks have entered into "liquidity swaps." These liquidity swaps involve European banks selling (the illiquid) securities to counterparties (i.e., investment banks or insurance companies) in exchange for a discounted value of government bonds or other liquid assets. In turn, the European banks utilize these swapped liquid assets as collateral to secure loans from the European Central Bank (ECB).
Demand for liquidity swaps has increased in Europe in recent months, particularly between European banks and insurers. According to a guidance consultation paper written by the United Kingdom's Financial Services Authority (FSA) in July 2011, liquidity swaps between European banks and insurers are an increasing trend, causing the FSA to become concerned about the spread of systemic risk (that is, resulting in continued collapse of the financial system) in Europe. The suggested rationale is that liquidity swaps offer a solution to insurers' search for yield, and they also fulfill the banks' need for liquidity. For a fee, the banks can pledge illiquid structured assets (at a discount) in return for liquid collateral.
The FSA also is concerned about the interconnectedness between the insurance and banking sectors, meaning that a bank failure could also cause distress or failure among connected insurance companies. Thus far, we have not seen any evidence that insurers in the United States have engaged in this activity. However, the Capital Markets Bureau believes that liquidity swaps could present issues to be concerned about if U.S. insurers become active in this market. If U.S. insurers did become involved in this market, then they might be reported as either a repurchase agreement, which we do not view as appropriate, or as a sale and long-term purchase commitment.