What AM Best Says
AM Best: Low interest rates, potential ‘fallen angels’ challenge life/annuity writers.
- John Weber
- October 2020
Economic turmoil may cause more 'fallen angels,' investment-grade bonds that drop to junk, said Associate Director Jason Hopper and Financial Analyst Igor Bass, both of AM Best.
The insurance industry overall has tangled with the low interest rate environment for the past decade, but it's been a thornier issue for the life/annuities sector, especially amid the economic impact of the COVID-19 pandemic. A Best's Special Report, Interest Rates: Different Impact Severity, Different Strategies, outlines the steps that life/annuity insurers have taken to de-risk portfolios.
Following is an edited transcript of the interview.
The analytical look here split this life/annuity sector into separate parts—interest-sensitive companies versus noninterest-sensitive companies. Can you detail some of the differences between these two groups?
Hopper: So the ultimate goal here was to see how strategies diverged in terms of investment strategies and in combination with reacting to changes that they had made on the product side, whether it be lowering crediting rates or things of that nature.
As you said, we split the insurance industry into two camps based on product profile. One was interest-sensitive companies, which primarily are individual or group annuity writers, deposit-type contracts or interest-sensitive life products as defined by the National Association of Insurance Commissioners.
So we split these companies based on a reserve in premium mix, and we found that there are twice as many noninterest-sensitive companies as interest-sensitive. But on the flip side, interest-sensitive companies command about three-quarters of the total industry's assets.
There may be more fallen angels in the financial crisis as this pandemic continues to move on. With that, as bonds start or continue to get downgraded, insurers are going to start facing higher capital charges.
How much do the operating results and performances vary between the two?
Bass: That's an interesting question where results could significantly vary between the two. Interest-sensitive companies represent a quarter of the portion of the companies but typically generate a majority of the earnings. The pretext and their operating earnings have been consistent for the most part for the interest-sensitive companies—but more fluctuation among the interest-sensitive companies over the past 10 years—but still remaining fairly positive.
Also, I wanted to mention the yields have been fairly declining over the past couple of years, more so for interest-sensitive companies than for noninterest companies. The interest-sensitive companies have a tendency to reach for the higher yield and that's where you have more risk involved in their portfolios.
From a life/annuity product standpoint, what moves are insurers making to de-risk?
Bass: Some of the moves that insurers are making to de-risk are cutting back on certain products, for example, UL (universal life) with secondary guarantees. They're curbing certain sales in new VAs (variable annuities) with living benefits.
They are favoring fixed-index annuities and indexing universal life products that have lower guaranteed minimum interest rates. They're also trying to lower guaranteed minimum interest rates in their portfolios, as well as divesting enforced legacy annuity blocks and raising some of the writer fees, basically trying to get rid of some of the richness of the benefits.
They're also trying to promote new products like the registered index-linked variable annuity, which shares some of the downside with high risk for the policyholder. So they're trying to do different things, especially trying to divest their portfolio with the richness of the benefits, basically getting rid of the secondary guarantees in the portfolios.
What are you seeing on the investment allocation side?
Hopper: Building on everything that Igor had just said, interest-sensitive companies have a larger need to maintain yields and limit spread compression based on their interest-sensitive business. So knowing that, allocations do differ between these two sets of companies based on product profiles and their matching asset liability management. One thing that we have seen across the industry is the move down the credit scale. We've seen NAIC 2 bonds becoming an increasing share of the overall bond portfolio.
However, interest-sensitive companies have nearly one and a half times the exposure to NAIC 2 bonds as noninterest-sensitive companies—roughly, about 36% of invested assets. This is becoming more of a concern now in the face of COVID, as there may be more fallen angels in the financial crisis as this pandemic continues to move on. With that, as bonds start or continue to get downgraded, insurers are going to start facing higher capital charges. Another investment class that we've seen an increase in is private placements. Interest-sensitive companies have double the exposure as noninterest-sensitive companies, and we have seen widespread growth among this asset class as three-quarters of interest-sensitive companies invest in private placements versus less than 48% for noninterest-sensitive companies.
The report notes that while commercial mortgages remain a key investment strategy, there's been a shift in the quality due in part to COVID-19. What did your analysis show?
Hopper: Historical performance has been great for commercial mortgages throughout the insurance industry. Yields had been declining, but they are still greater than bonds, so it is still a favorable asset class from that perspective. Quality is deteriorating, more so from CM1 down to CM2. But we've noticed that these efforts are more to increase yield as opposed to deteriorating conditions so far.
That may change due to COVID. The lack of economic activity could affect the operating income at the underlying properties, specifically hotels and retail-type properties. This could lead to declining valuations and higher loan-to-values.