The Dodd-Frank Effect

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The Dodd-Frank Effect: The Insurance Industry

Executive Summary The financial crisis of 2008 was cause by many factors within the United States financial system. Although the actions of insurance companies were not a key factor, they did adversely affect the industry and amplified the downward affect on financial markets. Insurance companies were adversely affected through the devaluation of their investments as a result of the collapsing mortgage market, depletion of capital, and increases in credit default swaps. Some insurance companies improperly managed risk and experienced issues with liquidity as claims and collateral calls were made and subsequent credit rating downgrades ensued. The US government attempted to fix these issues and prevent further failures by creating various federal oversight entities under the Dodd-Frank Act. Dodd-Frank also classifies many insurance companies as Nonbank Financial Companies, which are subject to more stringent regulations. Dodd-Frank takes into account the importance of the insurance industry and adequately made regulatory changes. The solutions to the issues in the Dodd-Frank act should be beneficial in preventing future failures. Problems in the Insurance Industry The financial crisis in 2008 was not largely caused by the actions of insurance companies, but did adversely affect the insurance industry and in certain cases exacerbated the pressures on financial markets. The insurance industry remained relatively stable overall through the crisis even though some insurance firms saw significant losses and required government assistance. The issues were, for the most part, seen in mortgage insurers, life insurers, financial guarantee insurers, and large insurance dominated financial groups. Mortgage insurers were most rapidly hit by the crisis due to mortgage credit risk exposure in the collapsing US mortgage market. The core business model for mortgage insurers is to guarantee financial service companies that their individual or portfolio of mortgages will retain their value. As the value of many mortgages in the market drastically declined the insurers realized significant losses and depletion of capital buffers. Some of the largest US mortgage insurance companies posted significant quarterly and year losses in 2007 and at least one of the ten largest had entered a run-off by 2008. These losses had a greatly adverse effect on share prices of mortgage insurance companies, which lead to a large increase in the price of credit

default swaps on the firm. Increases of prices on credit default swaps put downward pressure on financial markets. Life insurance companies were affected in a different manner. Market valuation pressures significantly declined the values of life insurance companies’ investments, specifically in stocks and mortgage-backed securities. Life insurance companies also experienced a rise on the liabilities side of the balance sheet as their variable annuities contracts became increasing expensive to fulfill with deteriorating capital market valuation and low or moderate government bond interest rates. Hedging strategies for these companies drastically increased due to high volatility in the market and further decreased profit margins. Possible credit rating downgrades posed numerous adverse consequences as well. Large financial guarantee insurers lost their triple-A rating during the crisis, which was the core of their business model in essentially renting out their high rating to lower-rated issuers. Financial guarantee insurers also tend to be highly leveraged and when they need to deleverage, as they did during the crisis, they add dislocations in credit markets, amplifying systemic risk. Difficulties experienced by these companies trickled down to the enhancements they provided and negatively affected the banks, other institutions, and markets that relied on the insurance they provided. Thus, the effect exacerbated downward pressure on financial markets....
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