Insurers traditionally have dominated the market for long-duration MBS, reaching well beyond where banks and GSEs often go and often buying more for yield than for potential total return. The duration of their liabilities and their accounting environment push them in this direction.
Insurers effectively borrow a stream of policy premiums and use it to buy assets. Liability duration and cost depend on whether the insurer writes property and casualty (P&C) policies, life policies, or both. P&C insurers often need good liquidity to meet a steady stream of claims—roof repairs after storms or automobile repairs after traffic accidents, for instance—so their liabilities are short. Life insurers usually pay claims years or even decades after receiving premiums, making their liabilities very long. The cost of these funds is usually very difficult to pinpoint. It depends largely on the amount of competition among insurers to write policies and on the returns either promised or sometimes guaranteed by the policies. A lot of competition raises the cost of insurers' funds; a lack of competition lowers it. Many policies guarantee minimum returns. From 2001 to 2005, for example, guaranteed minimum returns created a relatively high cost of funds as yields on MBS and other investments fell. In general, few mortgage investors have been able to compete with insurers in accumulating large amounts of long, low-cost liabilities. These funds take time and hard work to develop, however, and insurers lack the banks' or GSEs' ability to borrow quickly and take advantage of temporary market opportunities.
Leverage at insurers varies too much to make a general statement. It depends on the type of policies written. Variable annuities or other money management products require little capital. Term life insurance and other guarantee products require more capital. At insurers, however, leverage seems to have less of an influence on investment strategy than at other portfolios, although it clearly affects returns to shareholders.
In insurance company portfolios, MBS competes against a wide range of fixed income assets, from government and agency bonds to public and private corporate debt to whole commercial loans, and so on. In the 1990s, for example, insurers have been a larger presence in the corporate bond market than they have in MBS. Since insurance portfolios tend to hold assets for long times or even to maturity, they can afford to own somewhat illiquid securities. The returns from these alternative investments in theory should allow the company to meet claims from customers, cover operating costs, and produce a profit for shareholders.
Insurers face the same set of issues as the depositories and the GSEs when it comes to accounting for investments. Book-yield accounting keeps these portfolios focused more on yield than on the potential price performance of their assets. Insurance portfolios also tend to avoid both gains and losses on sale. Often insurers will sell securities only if they also sell another security with an offsetting gain or loss.
Insurers' portfolios also reflect the influence of regulators. State insurance commissions technically regulate most insurers, with each state free to differ in their requirements for doing business in their state. State commissions coordinate the regulation of multistate insurers through the National Association of Insurance Commissioners (NAIC). But the most influential voices on insurance companies come from the national rating agencies—Standard & Poor's, Moody's, Fitch and A.M. Best among others—since the customers of the insurers look to these agencies for indications of the insurers' ability to pay claims. Standard & Poor's has been most active in its oversight of insurer portfolios. Its main influence comes through the capital requirements that it sets for insurers in different ratings categories. The capital requirements for MBS reflect both its small risk of default and the impact of negative convexity or prepayment risk. Standard & Poor's also sets capital requirements for corporate bonds. As the capital requirements for MBS and corporate bonds have changed over the years, insurers' mixes of assets have changed in response.
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