Withering on the vine

The effect of interest rates on key insurers

It is a "trillion-dollar question:" When will the Federal Reserve Board change its monetary policy and allow interest rates to edge up from their current scrapping-the-bottom-of-the-barrel levels? That’s how Robert Benmosche, president and CEO of American International Group, described the wrenching challenge driving the insurance world, whether it be carriers, agents, customers, investors, regulators, marketing experts or rating agencies.

Ratings agencies feel the same. In a recent report, analysts at Moody’s Investors Service called it a “key risk” in the U.S. life insurance sector. “We believe that life insurers are overly optimistic” in dealing with the issue, citing as one reason the fact that U.S. accounting standards permit the deferral of the recognition of changing economic conditions, such as low interest rates.

The Moody’s report also cites other factors that lead them to believe life insurers have been playing down the risk. Factors such as life insurers’ “robust earnings growth expectations (even relative to historical levels for benign periods) under an adverse macroeconomic environment and past underestimation of potential tail risk (e.g., variable annuities with guaranteed benefits and long term care insurance).”

The report also notes that as rates have fallen to unprecedented levels and remained there longer than expected, investor concern has intensified. This worrisome attitude has led to depressed stock valuations and wider credit spreads relative to non-financial sectors.

snl interest rate chart

“We believe that if rates remain at current levels beyond 2015, there would be significant earnings charges and loss of capital with many rating downgrades,” Moody’s reports. An extended period of low interest rates would also lead not only to significantly lower investment income, but also to higher statutory reserve requirements and meaningful DAC write-downs (on GAAP financials), weakening companies’ profitability.

According to the report, the most affected insurers would be those that have sizable exposure to fixed-rate immediate and deferred annuities; universal life and interest sensitive insurance policies with high minimum crediting rates; variable annuities with lifetime guaranteed income benefits; long-term care; and long-term disability.

Other Views

In a study conducted last fall, Conning, Inc. said that on June 1, 2012, the yield on the benchmark 10-year Treasury bond reached a 60-year low, falling to 1.44%. The report said the European debt crisis had precipitated this decline as foreign investors continue to seek the perceived safety of the U.S. bond market.

This is not only an issue for foreign and domestic investors; it is also a problem for property-casualty insurers. Since 1997, the book yield for property-casualty insurers has fallen from 5.7% to 3.7% at year-end 2011, a decline of 200 basis points, according to Conning.

Life insurers haven’t fared much better. Their book yield has dropped from 7.3% 1997 to 5.0% at year-end 2011, a decline of 230 basis points. (These book yields reflect net investment income as a percentage of average net invested assets reported for the U.S. property-casualty and life industries, respectively.)

This falling rate environment has created serious challenges for the insurance industry, which depends on investment returns to support the profitability of its products. Insurance companies must plan for declines in investment yield and income, but they must also balance the effects of a return to normal interest rates. And this is no small task. Balance sheet interactions between assets and liabilities create a complex challenge.

Benmosche touched on just that in his June 4 comments on the CNBC Newsmakers program. He warned that a hike in interest rates‑which some argue would fix the problem in one fell swoop‑would in reality create a disintermediation issue, with people leaving one annuity, depending upon penalties, to go to another.

“Just like a CD, you leave the bank, you have a CD, your rates are going up, you may choose to pay the penalty and move your money,” Benmosche said. “And so that’s where rates at some point in time could be a negative for the insurance company, but I think for the first 100 to 200 basis points, it’s going to be a big positive not only for AIG, which has a big fixed annuity block, a life insurance block, but it’s also going to help most insurance companies.”  

As to the timing by the Fed that would raise rates, he believes that will be when the Fed decides the job creation is there. “Look, one of the problems of job creation is you have many people who are eligible for or should have or normally would have been required to retire that are now worried about outliving their income, and so they’re not giving up their jobs and that’s sort of holding back the openings that a lot of young people could fill.” So, he said, “you’ve got to see that moving along a little bit better, see job creation and unemployment come down.”

In another recent report, Moody’s said a baseline economic scenario calls for a sluggish recovery and interest rates to increase slowly, but a plausible -- and less likely -- downside scenario would see stagnation and protracted low interest rates, reminiscent of Japan’s experience since the mid-1990s.

In its annual report to Congress about insurance, released June 12, the Treasury Department also voiced concern about the issue, stating that if the interest rate policy put in place by the Federal Reserve Board stays in place long term, it could severely affect the profitability of the U.S. insurance sector. And there’s a lot at stake.

The report says the life/health insurance sector posted record net premiums of $645 billion and net income of $40.9 billion for 2012.

These profits could be affected, however, if the Fed's policy of ultra-low interest rates continues. The report also echoes Benmosche’s concerns: that a decision to raise rates also poses risks for insurers by, for example, increasing unrealized losses in insurers’ fixed-income investments.

How to Cope

While the Moody’s report voiced concern over the implications of sustained lower interest rates, there have been clear signs recently that insurers are making product changes in response to the low interest rate environment, as in the case of MetLife, which redesigned its variable annuity products, reducing the roll-up rate.

MetLife responded by first shifting its U.S. business to focus on more profitable products. It did so by redesigning its variable annuity products, reducing the roll-up rate and the withdrawal rate. Several weeks later, it announced plans to merge its three U.S. life insurers and a Cayman Islands-based reinsurance captive “to create a larger, well capitalized U.S. life company.”

MetLife is one of least five large life insurers that have advised annuity owners over the last 16 months that they are either not accepting or restricting additional money for older VA policies with guaranty riders whose yields exceed six percent.

Steven Kandarian, MetLife chairman and CEO, said the company is also significantly reducing its footprint in the VA market, from a high of $28.4 billion in 2011, where it was rated No. 1 in the market, to $17.7 billion in 2012, to an estimated range of $10 to 11 billion for 2013. 

Besides MetLife, other insurers that have blocked or limited contributions to older contracts are Allianz Life Insurance of North America, AXA Equitable Life Insurance, John Hancock and Prudential Financial Inc. The Hartford, a prominent player in the VA market, has dropped out, reducing its life insurance business significantly.

In a recent conference call with analysts, Jay Wintrob, president and CEO of AIG Life and Retirement and executive vice president of parent company AIG, said that the vast majority of AIG’s variable and indexed annuity products include guaranteed lifetime withdrawal riders. This is because consumers are focusing more on generating a dependable stream of income during retirement and less on seeking higher investment returns -- and the related risk of doing so -- in order to accumulate greater savings.

At the same time, some foreign insurers are exiting the market at least in part due to the interest rate environment. Aviva plc. is one example.

Moody’s Vice President Neil Strauss said that many factors contributed to Aviva's decision to sell its U.S. operations. He cited the weak macro-economic environment, which has impacted European-based financial companies; the low interest rate environment in the U.S., which has made annuity businesses significantly less valuable; and “regulatory issues such as Solvency II, which have the potential for added capital requirements for the overall group.”

Strauss also said that a sustained low interest rate environment could lead to consolidation in the life insurance industry ultimately. “If this environment persists, it will impact a number of players,” Strauss said. The protracted low rate environment was one of the contributors to a realignment of the life insurance industry in Japan. However, “in the U.S., we have not seen much M&A-related actions,” he said.

Insurers are also changing their policies on the investment side in order to increase yields. Mary Pat Campbell, a vice president at Conning, said that in the last three years, life insurers have been investing more directly in commercial mortgages. They have also increased the investment allocation into acquiring corporate bonds with longer maturities. Increases in these investment classes have been offset by decreasing allocations to Treasury securities in comparison to prior years.

Campbell said there was a “race to safety” when life insurers first began to feel the impact of the latest, severe recession, in 2009, with increased allocation to Treasuries and cash. These investments also required lower capital provisions at a time when statutory capital was reduced due to the crisis.  But, in 2011 and 2012, life insurers increased allocations to other asset classes in accepting more risk for greater return, as their capital positions recovered. As for bonds, Campbell noted that the allocations have shifted to longer maturities, which can increase sector concentration risk as issuers of longer-dated bonds tend to be concentrated in fewer areas, such as utilities.

In addition, the credit quality mix of the bond portfolio has shifted toward somewhat lower quality. Campbell says this was partly due to downgrades of bonds already in the portfolio, but also due to modest increases in purchases of lower-quality investment grade issues that would afford higher yields for the increased risk.

Conning recently announced two new investment strategies to help insurers combat the low interest rate environment. The first is the purchase of master limited partnerships. These are publicly-traded partnerships that can provide attractive levels of after-tax yields, enhanced portfolio diversification and the potential for capital appreciation and participation in favorable trends in the U.S. energy sector.

Conning’s asset management unit has also formed a strategic alliance with Ramius Alternative Solutions LLC (RASL), which develops and manages customized alternative investment portfolios, to jointly develop a variety of alternative investment strategies to meet the specific needs of insurance companies.

In a statement, the two companies said they believe that certain strategies traditionally employed by hedge funds may enhance the risk-adjusted returns and diversification of institutional portfolios. Many insurers, however, have avoided direct investments in hedge funds due to concerns about high capital charges and high fees, as well as the lack of transparency and liquidity.

Conning and RASL are developing tailored strategies for insurers that utilize a variety of liquid instruments created in recent years -- including exchange-traded funds and total return swaps -- that are designed to produce returns that have low correlations to existing client portfolios.

“This unique approach provides exposure to sources of return traditionally available only to investors in hedge funds but with significantly lower fees and capital charges as well as greater transparency and liquidity,” the companies announced in a statement. “We believe the investment strategies we are developing with RASL are truly innovative and will be of considerable value to insurers,” said Woody Bradford, president and chief executive officer of conning.

Insurers are altering investment mix as a result of this -- not major shifts, but more private placements, more commercial mortgage loans, more equities and more bank loans. But on the margins, not a wholesale shift.

Grant Thornton insurance practice members are also pointing out that Prudential, MetLife and AIG are among those insurers moving into the healthcare field by rolling out supplemental health products. These are products designed to protect income in cases of diseases and accidents, a market dominated by Aflac. Insurers are doing so in order to be involved with more profitable products that also involve less risk.

Moody’s Strauss also said there has been an impact from the present low interest environment on the long-term care market. Within that industry, low interest rates contributed to companies withdrawing from the market as their long-term investment assumptions could not be met in the current environment.

In general, although interest rates remain a concern, it has taken time for the financial impact to be felt broadly in companies’ reported results. “One reason that it is not an immediate crisis for these companies is the investment portfolios that are backing the reserves have a low portfolio turnover rate, which in turn slows portfolio rate declines,” said Strauss. “The second reason is that for products such as fixed annuities, companies have been managing down the crediting rate they pay policyholders so as to maintain spreads. However, over time, as companies near contractual minimums, the financial impact will worsen.”

The third reason, as cited earlier, is that financial reporting rules do not require immediate recognition of changes in interest rates.

“Companies don’t have to reflect current interest rates immediately, which allow them to plan for a soft landing on their reserve assumptions as accounting rules do not require immediate recognition of changes in interest rates. However, each successive year of low interest rates increases the likelihood that eventually companies will need to recognize the full negative financial impact,” Strauss said.

Benmosche’s comments about the “trillion-dollar question” were virtually mirrored in a meeting Fed chairman Ben Bernanke had with reporters June 19 after the Fed announced it would soon pull back its stimulus efforts.

Bernanke said if the economy continues to improve, the central bank could start winding down its asset-purchasing program towards the end of 2013 and wrap up in 2014. Fed officials predicted that unemployment will fall a little faster this year, to 7.2 percent or 7.3 percent at the end of 2013. They think the rate will be between 6.5 percent and 6.8 percent by the end of 2014, better than its previous projection of 6.7 percent to 7 percent.

The Fed said it would keep short-term rates at record lows at least until unemployment slides to 6.5 percent. Bernanke emphasized that 6.5 percent unemployment is a threshold, not a trigger: The Fed might decide to keep its benchmark short-term rate near zero even after unemployment falls that low.

The Federal Open Market Committee was “more hawkish than we expected,” Goldman Sachs economists Jan Hatzius and Sven Jari Stehn said in a commentary. "Our takeaway is that the risk to our forecast of quantitative easing tapering starting in December has increased."

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