#Low #life #insurance #rates
Low Interest Rates
Last Updated 9/21/2017
Issue: The persistent low interest rate environment has had a notable impact on many segments of the economy, including the life insurance industry. Interest rates declined significantly for about 8 years following the 2007-2008 global financial crisis. Historically low rates still persist despite recent action by the Federal Reserve (Fed). Persistent low interest rates are identified as a major threat for life insurance companies, given their rate-sensitive products and investments.
Overview: Since 2007, the Federal Reserve (Fed) has used a variety of tools to stabilize the financial system, foster economic growth and keep interest rates low. It dramatically lowered the Fed Funds Target Rate to effectively zero where it has stayed since 2008. The Fed’s quantitative easing (QE) program, or large-scale purchases of long-term government bonds and other securities, in 2008, 2010 and 2012 pushed the benchmark 10-year Treasury yield down from 4.7% at the start of 2007 to 1.9% at the end of 2011. Following the gradual phasing out of the bond-buying program by the Fed, the benchmark rate moved up to 3.03% at the end of 2013, before slowly declining back to 2.27 % at the end of 2015. In 2015 the Fed raised its key interest rate for the first time in nine years followed by another modest increase of 0.25% in December 2016. The Fed left rates unchanged in February 2017 after raising its benchmark rate in December to a range of 0.5 percent to 0.75 percent and has suggested three rate hikes are likely in 2017. Fed Chair Janet Yellen has cited the next three policy meetings – in March, May and June – as possible occasions for a rate increase.
According to the minutes from the Federal Open Market Committee’s most recent meetings, which occurred on January 31 and February 1, both short- and long-term interest rates will be moving up over the next few years.
The Fed still has the same two goals: low unemployment and stable inflation and according to the meeting minutes, there has been progress towards both those goals. Inflation has remained below the Fed’s 2% target and the 4.7% unemployment rate is consistent with the Fed’s maximum employment objective.
The recent low interest rate environment has been a key concern for U.S. life insurers. Life insurance companies face considerable interest rate risk given their investments in fixed-income securities and their unique liabilities as their assets and liabilities are heavily exposed to interest rate movements. Interest rate risk can materialize in various ways, impacting life insurers’ earnings, capital and reserves, liquidity and competitiveness. Moreover, the impact of a low interest rate environment depends on the level and type of guarantees offered. Life insurers’ earnings are typically derived from the spread between their investment returns and what they credit as interest on insurance policies and products. During times of persistent low interest rates, life insurers’ income from investments might be insufficient to meet contractually guaranteed obligations to policyholders which cannot be lowered.
Persistent low interest rates can also affect earnings and life insurers’ liquidity. Liquidity management is critical for life insurers. As part of asset-liability management (ALM), life companies strive to match liability cash flows with asset cash flows to avoid setting up an additional asset-liability mismatch reserve. During periods of low interest rates, assets and liabilities cash flows can be seriously mismatched, exposing insurers to losses from uneconomic asset sales to meet current obligations to policyholders. While under conditions of persistent low interest rates, life insurers’ earnings are squeezed, liquidity demands tend to decrease as policy-holders are more likely to keep their money in life insurance investment products, such as annuities, due to the scant availability of higher-yielding alternatives.
Insurers have various tools to address the risk of persistently low interest rates. Increasing the duration of their assets to ensure better matching between assets and liabilities is at the core of life companies’ interest rate risk strategies as part of their overall ALM. Insurers also can lower the terms of new policies (e.g., by lowering guaranteed rates), thereby progressively lowering liabilities. For more on the impact of low interest rates on life insurers’ and how life insures’ counter low interest rates, please see “CIPR Study on the State of the Life Insurance Industry: Implications of Industry Trends.”
Rising interest rates should improve life insurers’ cash flows, relieving some of the pressure related to reserving. In addition, investment income trends may become more promising, helping insurers recover their capital position.
Status: The NAIC has been actively monitoring the low interest rate environment. An NAIC study of the impact of the low interest rate environment on life insurers was recently updated covering the 2006-2015 calendar year period. The data used was sourced from the annual statements of 713 life insurance company legal entities whose reserves represented 99% of the total industry life insurance reserves during that period. The study showed a squeeze in the spread between the net investment portfolio yield and the guaranteed interest rate during that period, particularly from 2008 to 2009 namely, at the peak years of the global financial crisis. Total industry reserves grew from $1.98 trillion in 2006 to $3.14 trillion by the end of 2015 as a result of the low interest rates during that period.
The study found that while the recent period of the low interest environment created spread compression on earnings, it did not materially impact life insurers’ solvency. To manage their interest rate risk, life insurers are matching their asset and liability cash flows. Statutory valuation law requires insurance companies to perform an annual cash flow testing exercise where the life insurance company must build a financial model of their in-force assets and liabilities. The company must run the financial model for a sufficient number of years, such that any remaining in-force liability at the end of the projection period is not material. Most companies run both a set of stochastically generated interest rate scenarios (typically 1,000+ scenarios), as well as a set of seven deterministic interest rate scenarios prescribed by state insurance regulators.
Such interest rate scenarios provide a good set of stress tests to help ensure life insurance companies have either well-matched asset and liability cash flows or have established additional reserves that are available to cover any interest rate or reinvestment rate risk embedded in their balance sheets. The Standard Valuation Law (#820) requires life insurance companies to post an additional reserve if the appointed actuary determines a significant amount of mismatch exists between the company’s asset and liability cash flows. As part of this study, the NAIC pulled the additional reserves liabilities established by companies at year-end 2012. The life insurance industry posted an additional asset/liability cash flow risk reserve of $9.7 billion.