Surge in Commercial Bankruptcies Reflects High Inflation and Interest Rates

Commercial bankruptcies have increased significantly in 2023, fueled by inflation, high interest rates, and the run-off of pandemic-era government assistance.

Though the insurance industry generally weathers economic stress better than other industries due to its inherent conservatism and regulatory safeguards, the increase in bankruptcies signals a need for heightened caution when it comes to investment portfolios. Insurance companies are already seeing some investments underwater as high interest rates depress bond valuations on existing securities.

Commercial bankruptcy filings had dropped in 2022, which registered a 5% decline from 2021 filings. However, some of that decline is attributable to the lasting effect of Covid-19-related government assistance.

The total number of U.S. commercial bankruptcy filings rose 18% to 12,107 in the first half of 2023 compared to the same period in 2022, with one of the biggest jumps seen in Chapter 11 filings, which soared 68% in the period to 2,973, according to data from Epiq Bankruptcy, which tracks bankruptcy trends in the U.S.

Small business bankruptcies, which are reflected in Subchapter V elections under Chapter 11 filings, showed a 55% increase in filings to a total of 814. However, some of that increase may reflect changes in eligibility filing limits.

The beginning of 2023 brought increasingly high inflation and interest rates and the end of pandemic-era assistance programs and lender forbearance. All these factors contributed to the growth in debt load for many companies.

Weakness in the retail sector was reflected in high-profile bankruptcies like Bed, Bath & Beyond. Still, filings were up in all categories and among small businesses as well as large corporations.

Impact on Insurance Companies

This is a time of caution for insurance companies when it comes to managing their investment portfolios. Insurers invest heavily in bonds, and bond yields are under pressure from the high interest rates. Though the Federal Reserve refrained from hiking rates again this month, Fed Chairman Jerome Powell suggested another small hike may be on the horizon. Starting in March 2022, the central bank made 10 consecutive rate hikes before pausing in June 2023, then raised the federal funds rate again in July to the current range of 5.25% to 5.5%, a 22-year high. It will remain at that level while the Fed evaluates economic data.

For insurance companies, this means all investments in securities – equities or bonds – must be scrutinized more closely, and investment advisors must perform due diligence to support new and existing investments. Credit rating status on bonds is a key indicator of their risk quality.

An additional cautionary factor in today’s economic environment is that the search for yield has influenced investment managers to take greater risk by adding higher-yielding Schedule BA assets, which are typically long-term, illiquid investments, to their portfolios. There is nothing wrong with this investment approach, but it is generally an area that takes specialized knowledge, consistent due diligence, and monitoring by the investment committee and the company investment advisor.

Recommendations

Insurance companies are advised to tread cautiously as this high interest rate and increasing debt default environment persists. Specifically:

• Don’t rest on your laurels. The fact that insurance companies typically weather economic stress better than other industries doesn’t mean they are invulnerable. Be alert.
• Exercise caution with stock and bond investments. Beware of investment targets that may become bankruptcy candidates (e.g., credit rating scrutiny). Be careful of unusually volatile industry sectors.
• Ask your investment manager or advisor for a detailed cross-industry analysis to help minimize risk with new investments.
• If an advisor recommends a Schedule BA type investment, ensure that the advisor is a specialist in the industry, the vehicle being suggested, and is well-informed about its risk profile.
• Be aware that your auditor will carefully assess the credit ratings in the industries where your investments are concentrated. Avoid surprises by investigating those credit ratings yourself ahead of audit season. Revisit your permanent versus temporary impairment criteria and be prepared to discuss those investments on the borderline.

The Outlook from Here

Over time, persistently high interest rates tend to impact businesses in all sectors, discouraging lending, capital investment, and growth. We will continue to see high bankruptcy rates, particularly in specific vulnerable sectors. This should increase the scrutiny the insurance industry investment committees require on their independent advisors.

The rising interest rate environment has impacted insurance company bond valuations heavily, leaving most in an unrealized loss position. Hopefully, this is temporary but may last longer than desired and challenge impairment philosophy. Most insurance companies follow their investment policies closely, and any strain in the policy parameters produced by non-performing or underwater investments is generally dealt with before it becomes extreme.