Life insurers are France's largest institutional investors. Alain Lemoine assesses how they are responding to the current crisis

As the economic and financial fog thickens it is difficult to see where French institutional investors are heading. One reason is because they, like others throughout the world, don't know themselves. But if there's not much to see, there's a lot to say.

First, one can try, using their end-2007 accounts, to understand where they came from before the crisis unfolded. Second, one can guess how they've been affected and have responded to the crisis in late 2008 until now. And third, one can anticipate the near future based on several scenarios.

French institutional investors have been lucky to enter the crisis with a less vulnerable profile than their counterparts in other countries. They have always been light on equities, where average losses in 2008 were 40%. The 2008 Invesco-sponsored European Institutional Asset Management Survey noted that French institutional investors had on average 27% in equities, compared with 55% in the UK and Ireland and added was three times as much investment in government bonds as in corporate bonds.

Of course, situations differ from an institution to another. The equity exposure of the Agirc-Arrco retirement institutions was about one third, while that of the reserve fund, the FRR, it was more than 50% for the French Retirement Reserve (FRR) and about the same for smaller retirement institutions with long term liabilities, like the French doctors' scheme CARMF.

According to data from the French insurers federation (FFSA), life insurers, which with more than €1.1trn under management, equating to some €100,000 per subscriber) are the country's largest long-term institutional investors and have an average equity exposure of about 20%. But this figure includes all kinds of mutual funds, which are considered as equities in insurance accounting rules, held on behalf of unit-linked policyholders. However, equities held on their own behalf amount to well below 5%, probably in a 2% to 3% range.

In addition, most of French institutions have retained relatively cautious accounting standards and although there was some exposure to risky assets like asset backed securities (ABS) or credit default swap (CDS), they were more spectators of than actors in the chaos.

And even more crucial, they are not squeezed by short-term liabilities and liquidity dilemmas.

Establishing how they have been affected is more difficult, as published figures evidently reflect a considerable communication effort to hide any signs of stress that could trigger more troubles.

Standard & Poor's rates about 40 insurance players in France, including some 15 AA-rated and 20 A-rated institutions. Until recently such ratings were considered ‘investment grade'. Of course it does not mean they would not be downgraded if things got worse. So how could things get worse?

Let's scare ourselves. Leading French institutions, and life insurers in particular, face three major dangers. The first a sudden and high increase in all kinds of debt, especially government bonds, as the inflationary effect of budget deficits and debt raise concern about their solvency. A second scenario would be a rise in default rates among corporate borrowers that would create liquidity problems, price falls and valuation nightmares for corporate debt securities, just as with ABS when default rates in securitisation vehicles of sub-prime lending started to jump. Third would be a prolonged zero interest rate monetary policy in a deflationary environment.

A sudden increase of more than 2-3% in long-term rates could trigger an opportunistic switch of savings out of life insurance in search of better returns. Insurers estimate they could resist if rates increased between 1% and 2%, would face difficulties and casualties if rates increased by about 3%, and would be burnt out if rates increased by more than 3% or doubled, which would mean government bonds jumping from their actual low yield of 3.5% to 6.5% or more.

But even in that kind of emergency situation, life insurance institutions would not go bankrupt overnight like some banks did, because they would find ways to limit their short-term liabilities. Some restrictions could be put in place to restrain savers from exiting life insurance, as were used to restrain redemptions in some commercial money market funds in 2007 and in funds of hedge funds in 2008. Some policies have barriers written into them that allow insurers to block arbitrages out of their general assets in case rates increase too fast compared with their portfolio yield or past return.

Until now, these restrictions can only restrain arbitrages within unit-linked contracts, not stop withdrawals from life insurance contracts as a whole, but it might be different should their solvency be at stake.

Insurers are also wary of the necessity to avoid defaults affecting their portfolios on a large scale and so have adopted a more cautious investment strategy toward bonds. Most will not buy long-term corporate debt, especially in the banking sector, or even some European government bonds when they consider high spreads indicate a higher risk.

"We don't really believe Greece or Spain could go bankrupt or be forced out of the euro," explains the CEO of a French mutual life insurance company managing €10bn. "But they could face financing difficulties at some point which could imply rescheduling payments on their debt. That would be bad for institutional holders who would have to take provisions if the prices of these debts plunged further."

A third concern would be a prolonged low-yield and low-rates environment. This could lead to a Japanese-style scenario where interest rates stayed so low for so long that insurers could not generate enough financial revenues to cover their ongoing liabilities, which had not been priced for a zero interest rate environment.

Such an increase of life insurance liabilities would be very dangerous were it to coincide with a fall in the French appetite for life insurance. Such a reduction could be triggered by a growing fear about the safety of life insurance savings, a search for better opportunities or just a natural drawdown for demographic reasons, as baby boomers reach retirement age with a smaller pension and longer years to live on their savings, and could lead to a need to liquidate assets at huge losses.

However, there are good reasons to expect that such catastrophic scenarios could be avoided. One is that savings rates tend to increase rather than fall during economic crises. The growing ranks of unemployed workers need to draw on their savings at some point to maintain their living standards but people who have not lost their job tend to put more money aside.

Another reason for optimism is that, according to ALM consultants, life insurers have been successful in hiding part of their capital gains and financial profits by using accounting tricks, thereby building up a reserve by avoiding distributing chunks of their realised and potential gains to their policy holders. Today their solvency situation is probably more resilient, even in the face of a bad financial situation, simply because they can hide less revenue or pump in their reserves before they reach the limits of capital needed to match their solvency needs in the long term.

For example, a French insurer with a solvency ratio of 120%, means it covers 1.2 times the minimal capital requirement, or is 4% of the savings it manages. With a cautious approach to the profit and loss, it distributes only 3.8% to policyholders when the portfolio has a yield of 4.3% and puts 0.5% in hidden reserves each year. After the four years of the 2003-07 bull market the hidden reserves represent 4% of the managed savings. If it hides less each year, it gets more to meet liabilities, and if conditions worsen it can also tap the reserves to meet liabilities before tapping shareholders.

"Thanks to their positive cash flows, most insurance companies won't necessarily need to sell assets at substantial losses, even if their solvency ratios decrease strongly when their unrealised capital gains vanish, reducing their safety cushions," Standard & Poor's recently noted. "On the present situation, we don't think the insurance industry needs a massive public intervention as was the case for banks."

Indeed, French life insurers recently proved their resilience to market pressure on their solvency without tapping on public or shareholders' money. Rather in December 2008 and January 2009 they lobbied for changes in accounting regulations to allow them to reduce provisions on asset depreciations by lengthening the liability impact of the depreciation.

Given this institutional investor resilience, there is no fear for the moment of a systemic risk triggered by somewhat unlikely extreme or catastrophic scenarios. Nevertheless, many unlikely scenarios have developed in the last couple of years and betting it could happen to French institutional investors would be to rely more on hope than on rationality.