The Capitalization and Portfolio Risk of Insurance Companies

by Richard W. Kopcke
July/August 1992

The strategies of financial intermediaries in the United States presumed a stability of interest rates that began to break down in the late 1960s. Not only did rising interest rates during the past two decades tend to depress the value of the assets of all intermediaries, they also fostered competition among intermediaries as all sought new opportunities for profit. In order to cope, many financial institutions assumed new bets by "reaching" for riskier assets offering higher yields or by operating with less capital per dollar of assets. To varying degrees, many insurance companies have adopted these strategies.

Of all the remedies inspired by the recent investigations of the insurance industries, none appears to be more important than raising more capital. Insurers need to reduce their leverage if their contracts are to be as secure as they were supposed to be prior to the late 1960s. This article concludes that many insurers must increase their capital to cope safely with the consequences of an enduring slump in the value of commercial real estate, a substantial decline in corporate profits, or a significant rise in credit market yields.

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