What Role Could Insurance Premium Finance Have Played in Recent Bank Failures? (Part 2)

0
204


New You can now listen to Insurance Journal articles!

The longer the maturity and the lower the coupon, the more sensitive the note/bond price is to changes in interest rates.

To pause and reflect for a moment on what we’ve discuss so far, the price of the bonds held by SVB in their securities portfolio dropped in value. That change in their bond values on the assets side of their balance sheet caused a corresponding reduction in the bank’s imputed equity on the other side of their balance sheet. Remembering that “Notional” means, they have a theoretical loss, because it’s only a loss if SVB sells the bond (while the price is trading at a discount). As of the writing of this article, the U.S. bank regulators allow banks to maintain the value of their bond portfolio at “book value”, since the bonds pay-out the full face-value if held to maturity. The securities losses are recorded on the bank’s balance sheets as “unrealized” loss and do not reduce the bank’s regulatory capital ratios (which is a fancy name for the bank’s regulatory equity).

As the coupon for the same bond maturities rose, the value of bonds held by SVB became less attractive and dropped in market value. As the asset side of the bank’s balance sheet continued to drop by billions of dollars due to the decrease in the bonds, the equity side of the bank’s balance sheet fell correspondingly, causing short sellers to attack the stock price and the depositors to question the financial stability of the bank. Meanwhile, the short sellers continued the downward pressure on the stock price. The depositors’ concerns led to more cash withdrawals. The magnitude and frequency of the withdrawals snowballed to the point where SVB was forced to sell bonds to cover the depositor withdrawals.

This is the second in a two-part piece by Bill Villari, who has been in banking and premium finance for 34 years. Read the first part HERE.

At a high level, we understand that decreases in SVB’s bonds triggered the domino. The final killer-blow that lead to SVB’s precipitous demise was the rapid withdrawal of money by its bank customers. A rapid decline in the value of bank’s bond portfolio, caused an equivalent diminution in the bank’s Tangible Common Equity. The decline in tangible equity caused SVB’s depositors to question the stability of the bank (and short sellers attacked the stock). A large percentage of SVB’s depositors were high net worth individuals and technology companies with deposits in excess of the $250,000 insured by the Federal Deposit Insurance Company (FDIC). Technically, deposits greater than $250,000 would not be covered by FDIC if the bank failed. As the confluence of circumstances unfolded at SVB, customers with greater than $250,000 in deposits rushed to remove their uninsured deposits electronically. The ease of withdrawing money electronically, caused a wave of withdrawals killing the bank.

As a side note, much has been made of the fact that SVB had an open position for a Risk Manager for a year plus. I question how much that mattered. There are approximately 4,100 banks and 4,900 credit unions in this country. A significant number of them have large “unrealized” losses on their bond portfolios, and their tangible common equity has declined materially. Likely few, if any of those banks had open risk management positions. For 14 years rates were low. Banks with balance sheet liquidity naturally reached for yield, by buying long duration bonds. When the FED jack-up rates at the fastest amount in 42 years, these banks got stuck holding a bag of low coupon bonds that crater in value. No way for a Risk Manager, CFO or Treasury manager to have predicted the extent to which the FED had to raise rates to fight inflation. Remember, prior to the rate increases, SVB was in the enviable position of having balance sheet strength as defined by its liquidity and Tier 1 Capital. Ironically, banks that failed to attract depositors or were otherwise all loaned-up, had less “unrealized” losses in their securities portfolio because they didn’t have cash to burn buying bonds.

Now then, we finally get to the point of this article … what could banks have done differently, or more particularly, what asset could a bank have substituted on its balance sheets instead of the low coupon, long duration bonds that caused so much financial trouble. The answer is Property and Casualty (P&C) Insurance Premium Finance. P&C Insurance Premium Finance is the perfect substitute for bonds at a mid-sized bank. The asset is low risk, has solid yields and is substantially cash secured.

People look at signs posted outside of an entrance to Silicon Valley Bank in Santa Clara, Calif. on March 10. (AP Photo/Jeff Chiu)

Property and Casualty Premium Finance loans are short duration loans, typically nine to eleven months. While these types of loans usually have fixed interest rates since they are very short duration, they renew annually when the insurance policy(ies) renew, and therefore reprice annually at the then market price of interest. P&C premium finance loans would have provided above market yielded, below market risk and importantly, they are short in duration; thus, little to no rate risk.

Let’s take a deeper dive into how premium finance works. Insurance company’s offer commercial lines insurance policies for businesses from roofers to doctors to real estate owners and developers. The insurance protection is marketed to the insurance buyer through retail insurance agencies. A portion of commercial insurance policies sold in the U.S. insurance marketplace are Excess and Surplus (E&S). E&S policies have a unique feature in that the annual insurance policy premium is due at the time of purchase, referred to as the “inception date” or policy “effective date”. That’s different from our personal lines (car, home, boat) insurance whereby the insurance companies often offer monthly, quarterly or semi-annual payment plans with little to no interest, although there is typically a monthly installment fee of a couple bucks per payment. The E&S insurance premiums that require the insured to pay all up front, give premium finance companies a pitch to swing at. Since the annual premium in E&S policies are due at policy inception, buyers of this type of insurance often choose to finance their annual insurance policy so they can pay the premium in monthly installments rather than in one lump sum at the beginning of the policy. This enables the business-owner to synchronize their monthly insurance expense in the business with the monthly income from their business. Matching the business expense with the business’s income makes sense and the bonus for the borrower is these premium finance loans are tax deductible and do not typically affect the company’s corporate borrowing power.

Let’s unpack this a bit more…

We understand the rationale of spreading out the payment of a front-loaded insurance policy over several months of the policy period. The loans have a cost, both the annual cost of the insurance and the interest charge to the insured-borrower. These costs are passed through the borrower’s company income statement (Profit and Loss Statement (P&L); therefore, both the insurance premium and interest are tax deductible on the P&L.

Borrowing from a premium finance company is effectuated by a loan document called a Premium Finance Agreement (PFA). These are user friendly two-page loan documents that provide the premium finance company a Power of Attorney to cancel the policy and a right to the unused portion of the policy should the policy cancelled prior to the maturity date of the insurance policy. These premium finance loans do not require the voluminous loan documentation that a typical commercial or consumer bank loan requires. The right, title and interest in the insurance policy’s unearned premium provided by the Power of Attorney is the collateral for the loan. Pause and think about that for a moment … the unused portion of the insurance policy has a dollar value, the right, title and interest to that dollar amount, is the collateral for a premium finance loan.

These loans are often “fully secured,” meaning the dollar value of the unused portion of the underlying insurance policy premium would cover the loan balance throughout the life of the loan. In short, these are usually fully secured loans, that are short in duration. The interest is fixed, but the fixed rate is only for eight to eleven months; therefore, there’s little interest rate risk.

Banks are often the lenders to the insurance buyers in the premium finance marketplace, typically through their premium finance division. Banks are low-cost borrowers. Their pricing is usually equivalent to the weighted average pricing of their demand deposit accounts, or, their internal marginal funding cost. Banks with low marginal funding costs have advantages. The lower the bank’s borrow cost, the greater the spread between the cost of funding the loans and the interest rate on the loan. That spread in bank vernacular is called, Net Interest Margin, or “NIM”. The greater the spread, the greater the net income.

Since the average duration of the premium finance loan are nine months, the average duration in the entire premium finance loan portfolio is approximately half of that or, 4.5 months. Yields on a bank’s premium finance portfolio (averaging 4.5 months) approximate the average duration of the 30-year bonds. Think about that for a moment … These are extremely short duration loans (see above, the average duration of the portfolio is 4.5 months), YET yields are equivalent to long duration US Treasuries and MBS, AND, the loans are cash secured, AND interest rate risk is de minimus because these loans reprice about every nine months when the policy renews.

The note yield on premium finance loans are roughly equivalent to the long bonds. However, since these are short duration loans, a bank can exit quick in a crisis to shore up equity or deposits. Another plus is these premium finance loans allow the bank to match the short term liabilities of their depositors (or Fed borrowed funds) with a short term assets in a premium finance portfolio.

To circle the square, a portfolio of premium finance loans would have yielded SVB about the same or higher NIM as its the securities portfolio of long bonds, without being trapped in a long position. The yields on premium finance loans are above, or approximate investment grade returns of 30-year bonds. The loan duration is short and most of the loans in a premium finance portfolio are fully secured. The short-term premium finance loans reprice about every nine months, would have prevented these banks from having to report “unrealized securities loss” associated with convexity of their bond yield. A topic for another time, but, because of the cash secured feature, the risk weighting of the premium finance loan is, or should be, less than one!

Banks and credit unions should consider substituting their bond portfolios with short duration premium finance loans because these types of loans produce above investment grade long-bond returns, they approximate investment grade risk (since the loans are fully or substantially fully secured by the policy collateral), and, they have little to no interest rate risk.



Source link

LEAVE A REPLY

Please enter your comment!
Please enter your name here