Understanding the U.S. Budget and Debt Ceiling Situation: Minimal Impact on Insurers
Implications for the P/C Insurance Industry of the Government Shutdown and Possible Failure to Extend the Debt Ceiling
October 11, 2013
Two recent developments involving federal government finances—the October 1 shutdown of many federal government functions following a failure to agree on a new fiscal-year budget and the looming possibility that the current ceiling on the amount the government may borrow might not be raised before total debt reaches that limit (expected sometime in late October)—have become significant concerns. Some economists are predicting that one or both of these developments could have dire consequences for the U.S.—and perhaps the global—economy. However, even if the shutdown is prolonged and the debt ceiling not raised, this is not likely to impair the orderly functioning of the property/casualty insurance industry.
Federal Government Shutdown
There is increasing agreement among economists that a prolonged shutdown of a significant portion of the federal government’s operations will have a negative effect on the U.S. economy, possibly pushing it back into or close to recession. Note that the drag from the shutdown comes on the heels of the federal government sequestration which trimmed the spending of many federal agencies beginning in March 2013. Even prior to the shutdown, many forecasts for the near term were for limited real growth, generally in the neighborhood of 2 percent. Interest rates were expected to remain unusually low; inflation at roughly 2 percent per year. Corporate profits had been strong, and the stock market was having a good year until mid-August, when uncertainty about the budget and debt issues began to grow; since then (after a brief rise) it has trended down.
Forecasts for the effect of the shutdown vary. Monthly Outlook, published by Wells Fargo’s Economics Group on October 9, says “many forecasters have speculated that the government shutdown will shave 0.1 to 0.2 percentage points per week off fourth quarter [real] GDP growth. We see those estimates as bit high….” Swiss Re’s Global Economic Outlook, published October 8, estimates “the effect of a full-quarter shut-down” at 1 percent to 2 percent of [real] GDP.
For the last few years P/C premium growth has generally tracked nominal GDP (i.e., real growth plus inflation). Policyholder surplus also grew, despite several tough years of catastrophe claims, partly because of strong stock market growth. (P/C insurers owned over $418 billion of common and preferred stock as of year-end 2012), ending 2012 in its strongest position (in absolute terms and in relation of net written premiums) in its history.
If the premium/nominal-GDP relation continues and the shutdown persists, it seems likely that P/C premium volume growth would slow but remain positive. Most of the slowdown would be due to slower growth in the exposure base for various P/C coverages (i.e., fewer new cars bought, less payroll expansion, etc.). However, it seems reasonable to believe that, however long the shutdown persists, when it ends its effects would be relatively short-lived. For example, indications are that government workers will be paid retroactively, injecting some added spending power briefly into the economy.
Failure to Raise the Debt Ceiling
In contrast, there is growing concern among economists that a failure to raise the debt ceiling, possibly resulting in default on U.S. debt, would have catastrophic and long-lasting effects on the capital markets and on the U.S. economy. Because this has never happened before, predictions about consequences are sketchy. But it seems likely that U.S. government bonds will be treated as riskier than before, and—all else being equal—the prices of current U.S. government bonds will fall (more on this below). In addition, the uncertainty that this event creates will likely cause stock prices to plunge, at least in the short run. Back in August of 2011, when it appeared that the U.S. might not raise the debt ceiling and so might default on its debt, the stock market sank. On July 7 the S&P 500 closed at 1353.22. One month later it closed at 1119.46, down 17.2 percent. Note that this was the market’s reaction to the possibility of a debt default, which ultimately did not occur. It is reasonable to expect that the effect of an actual default would be orders of magnitude larger.
Directionally, the effect of these two capital market effects will likely shrink the asset values of insurers and, because they won’t affect insurer liabilities, will also shrink policyholders’ surplus. However, the extent of the asset and surplus shrinkage is likely to be manageable. U.S. P/C insurers owned $934.6 billion in bonds at year-end 2012 (59 percent of total assets), but only $84.8 billion in U.S. government bonds and only $98.5 billion in agency bonds. Moreover, most of the industry’s bond holdings (from all issuers) have relatively short maturities (57 percent of bonds have maturities of five years or less, and another 28 percent are bonds with maturities of 5-10 years).
Following the rise in interest rates for U.S. government securities, interest rates for other fixed-interest investments will likely also rise. This will actually benefit insurers, whose investment income is largely derived from bond coupons, and which has been suffering for the past half-decade as rates dropped to record lows.
Investment income is a comparatively small part of P/C insurer revenues when compared to the monies these insurers generate via premiums. Policyholder premiums paid to P/C insurers have totaled anywhere from $425 billion to $450 billion each year since 2003, with net investment gains ranging from $31 billion to $64 billion annually within this same time frame. A very small fraction of the net investment gains for P/C insurers come in the form of U.S. government bond income.
The main revenue streams of P/C insurers—mostly premiums for insurance coverage—are likely to be only mildly affected, at most. Premiums received in any given year generally cover P/C insurer claims and expenses for that 12-month period. As such, even if there were a drop-off in U.S. government bond income it would have an insignificant effect on insurers’ ability to pay claims and expenses.
Most P/C insurers are quite well capitalized, but the NAIC will likely review its risk-based capital requirements and will consider changes if it is believed to be necessary. For the industry overall, however, policyholders’ surplus—the excess of assets over liabilities (what companies in other industries call “net worth”)—was a record $614 billion at mid-year 2013.
One theoretical effect of a default is that interest rates on newly issued U.S. government bonds and most other forms of fixed income securities would rise. However, the extent of this happening depends on the degree to which investors can find sufficient substitutes for U.S. bonds that are as—or nearly as—secure as the U.S. bonds they would replace. A U.S. default does not change the uncertainties regarding the soundness of sovereign and related debts in Europe, which in the past (even in August 2011, after S&P downgraded U.S. bonds from an AAA rating) caused capital to flow into U.S. securities as a safe haven, raising their price (and therefore lowering their interest rates). The extent of the change in value of insurer bond assets depends on many things, but the net impact on the value of assets held by P/C insurers should be modest and manageable.
So, even when envisioning an extremely unrealistic scenario whereby all U.S. government bond holdings were valued at half their nominal value, P/C insurers would still have the assets they needed to cover all of their liabilities plus a “cushion” for unexpected claims equal to $500 billion, the rough equivalent of 12 Hurricane Katrinas, the costliest natural disaster in U.S. history.
If the budget impasse driving the government shutdown continues, the effect on the P/C insurance industry is likely to be felt as slightly decreased revenue and profits, relative to what insurers would experience under more “normal” circumstances. If the U.S. debt limit is not raised on or before the time debt reaches that ceiling, P/C insurers will likely experience both lower revenues and profits and some decrease in insuring capacity, as indicated by policyholders’ surplus. Since most of the industry’s revenue comes from premiums for the insurance it provides, and most of the outflows are for claims that are unrelated to the state of the economy or the soundness of U.S. debt, their business model somewhat insulates P/C insurers from the effects of a debt default. It is important to remember that insurer holdings of these investments are quite small, and the cushion of assets over liabilities (policyholders’ surplus) is virtually at its strongest level in history. Therefore, insurers would be able to pay claims, write and renew policies, and in general operate without impediment or interruption.