Insurers in shadow banking clothes

There has been quite a bit of press recently on the demise of the so-called "shadow banking system". As a reminder, these are institutions that fund themselves through short-term borrowing, investing the capital into longer term (and sometimes highly illiquid assets).


Up until recently, the culprits behind this highly risky (but in good times very profitable) trade have included hedge funds, structured investment vehicles, conduits, private equity funds and even money market funds.


I don't think anyone can now dispute that the unwinding of this trade will be nasty. What I want to point out is that there is one group of non-financial firms that have so far been left out of the debate: insurers.

The reasoning is as follows. How does an insurer make money? Well, if you believe their own financial statements it ain't through commercial judgement. A glance at the past 5 years combined ratio (a proxy for profit on insurance underwriting) shows that insurance per se has been unprofitable at some point, sometimes tragically so.

The white knight is investment income flowing from the balance sheet. When markets cooperate the returns are healthy, as in spite of regulation insurers can invest in some pretty racy vehicles (CDO equity anyone?). Their motivation is simple - to boost the P&L, you need high octane investments for your surplus capital.

AIG may be a special case, given that they were involved in heavy credit derivatives business. All the same, I think it is safe to assume that insurers will be paring back the rpm on their investments - expect more unwinding for some time to come.