Interest Rate Increases Posing New Challenges for Life Insurers
The Federal Reserve started increasing interest rates, something the life insurance industry sought for years. Fine-tuned investment portfolios, record capitalization and growth could make rate hikes less important than initially thought.
- Terrence Dopp
- May 2022
Life insurers spent more than a decade bemoaning low interest rates even before COVID-19 prompted central banks to ease monetary policy.
The decision by the U.S. Federal Reserve to keep rates low persisted after the Great Recession in 2008, when bolstering liquidity, and the overall economy, was a priority. Conventional wisdom saw any increase as a good thing. But with the first installment in March of what could be multiple increases in 2022, those who study insurance companies' balance sheets are warning that situation could present its own unique challenges.
Beyond just an increase in interest rates, the trajectory will be key, said Michael Siegel, global head of insurance asset management for Goldman Sachs Asset Management. In late March, GSAM released its 11th annual Global Insurance Outlook Survey of industry professionals worldwide, dubbed Re-Emergence: Inflation, Yields, and Uncertainty. “If we get a sharp, steep rise in rates, that will end up causing disruptions in markets. And volatility tends to be bad,” Siegel said. “If we get a slow, persistent rise in rates, at the end of the day that's preferable for the industry.”
In fact, GSAM found in the study that inflation and monetary policy were the top two concerns of professionals for the coming year with 28% and 20%, respectively. Those findings represented a sharp turn from prior years, when the two phenomena were largely overlooked. It was such a change that COVID-19 was ranked eighth on the list in proof of just how much difference one year can make. The survey of 328 mostly CIOs and CFOs was conducted before Russia's invasion of Ukraine triggered rounds of global sanctions that created a cloud over Western economies. Prior to the invasion, geopolitics ranked low on the list of concerns.
Life insurance is a famously long-tailed proposition. Grappling with obligations on their books that were written during periods of much higher rates, carriers went on a hunt for yield in recent years. This led them to find a greater interest in vehicles such as investing in collateralized loan obligations, private equity, real estate and growth through acquisitions that offered a larger return and were safe places to park some money. In CLOs, for instance, the money is derived from a spread of return relative to benchmark interest rates and life insurers proved more amenable than property/casualty carriers to step a bit further down the ratings scale in the hopes of greater yields.
Decoupling may be an extreme phrase, but life insurers took any steps they could to separate investment portfolios from rates set by central banks.
The Federal Reserve on March 16 approved a quarter-point increase and left the door open for as many as five or six similar hikes throughout the year, taking the advice of the Federal Open Market Committee. The move was aimed at curbing inflation that rose at an annual rate of 7.9% in early 2022, according to the consumer price index issued by the U.S. Bureau of Labor Statistics.
“In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook,” the Fed said in its announcement. “The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals.”
The approved hike was a step toward achieving a 2% inflationary target, and the board left itself room to deal with economic fallout that could arise from inflation, political events or the conflict in Ukraine. Adding uncertainty to the mix, yields on the two-year Treasury note recently rose above that of the 10-year note for the first time since 2019 and the pandemic lockdowns that promoted economic chaos. While not a definitive statement, such a flight to two-year safety across the broader economy is generally taken as a sign of investors girding for a recession.
Michael Porcelli, a senior director with AM Best who tracks life insurance and annuities, said carriers “are learning to live” in the universe of low interest rates. Citing the savings component of a typical universal life policy, he said too rapid of an increase could translate into policyholders jettisoning older products with lower guaranteed rates in favor of newly minted ones with the higher figure embedded in them. Currently, Porcelli said, guaranteed minimum interest rates on universal life policies hover around 2%-3%. If the U.S. benchmark Treasury goes up suddenly to as much as 7%-8% in a mirror of the consumer price index, he said it would prompt a shift in consumer behavior that doesn't play out in the favor of the status quo. A slow and steady trajectory, however, gives insurers the ability to adjust over time in a less-disruptive manner, he said.
“New entrants will come into the market and they're not going to be burdened by lower yielding asset portfolios and they can offer a higher guaranteed interest rate,” Porcelli said. “All of a sudden you would have all of this money that's in an interest-sensitive universal life policy surrendered and going to new competitors.”
Under that scenario, insurers could be forced to sell assets trading at lower prices to pay off those policies.
“If it's a boil-the-frog thing over time, it doesn't necessarily become a problem,” Porcelli said. “You might avoid a mass rush to the door of surrenders.”
Bottom Didn't Drop
The pandemic was a funny thing. The U.S. and global economies ground to a halt as lockdowns curtailed normal operations. But life insurers came through with limited credit losses and booming sales of new business in life and annuity products. As the health crisis took hold, AM Best lowered to negative its outlook on the life and annuity sector, only to raise it to stable in December 2021.
In a March 10, 2022, Best's Market Segment Report titled US Life/Annuity: Record Capitalization, Strong Liquidity, and Improved Earnings in 2021, AM Best found that, contrary to initial expectations, many companies in the sector reached record levels of capitalization, maintained strong liquidity, and saw their earnings grow during the period.
Matthew Reilly, head of institutional solutions at Conning, said life insurers in general have tuned their businesses well to deal with any eventuality or movement by the Fed. There could be some degree of realignment in product segments with an accumulation aspect, but he doesn't see the shift as being a major drag on the industry as those products became less attractive amid the low interest rates.
“They're pricing in their profitability already so whether they are selling a five-year annuity for 1% or 2%, they're not doing that on the assumption that rates are going to go up in the future,” he said. “You can see more flow into some of those spaces as yields rise and the overall competitive nature of those yields could become more appealing to consumers.”
Even with one increase, or several bumps in 2022, rates remain low comparable to before the financial crisis. Reilly said he doesn't see the trend of insurers expanding their investments to deal with lower returns reverting as rates go up. Pandora's box is an apt analogy, he said. “A lot of life insurers and P/C insurers have put in the time to research a lot of alternatives and options for the portfolios beyond what they'd been using for the past several decades. And that's led to higher yields that they're able to sustain whether rates are 2%, 3% or 4%.”