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Low Interest Rates Could Cause Changes In Reserve Calculations

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By Allison Bell

If corporate bond rates follow key Federal Reserve System benchmark rates to record low levels, insurers may have to change the rates they use in reserve calculations.

“That is a major change,” said William Seyboth, president of the CNA Group Benefits Division. “That one is very scary, if you do it unilaterally.”

Seyboth spoke in Chicago at a group insurance conference sponsored by LIMRA International, Windsor, Conn.

Actuaries use discount rate assumptions, or interest rate assumptions, and investment return assumptions when computing reserve requirements for long-term disability insurance policies, defined-benefit pensions plans, and other products that create long-term financial obligations.

The higher the discount rates and average returns assumed, the lower the premiums and reserve requirements have to be, according to insurance experts.

For years, actuaries assumed reserves could earn annual rates of 5% to 10% when invested in high-quality, low-risk corporate bonds.

Crawford & Company, for example, used a discount rate assumption of 7.5% in defined benefit pension plan calculations for 2000.

The Atlanta risk management firm used an expected rate of return on plan assets of 9.3% in the same calculations, according to the companys annual report.

Then, earlier this month, the Federal Reserve Board of Governors again tried to stimulate the economy by lowering the federal funds rate, a rate that banks charge one another, 0.25 percentage points, to 1.75%, down from 6.5% a year earlier.

Standard & Poors Ratings Services, New York, responded by requiring companies seeking top ratings for some financial transactions to assume a minimum investment return of 1.25%, rather than 2.5%.

Rates on corporate bonds have been much slower to fall than Fed benchmark rates: the average rate on a 10-year, top-rated industrial bond was 6.02% on Dec. 19, close to the average of 6.45% recorded a year earlier, according to Bloomberg L.P., New York.

But, if the world economy stabilizes and worries about war and terrorism ease, “renewed investor demand will contribute to a gradual tightening of credit spreads,” according to an S&P credit market forecast.

Seyboth, whose company is a unit of CNA Financial Corp., Chicago, warned against using complicated accounting maneuvers to compensate for the effects of weak operating profits and low interest rate assumptions.

Companies that set aside inadequate reserves when they sell new policies, or defer business acquisition costs over long periods of time, may improve their short-term profits, but they will weaken long-term profits, Seyboth said.

Reproduced from National Underwriter Life & Health/Financial Services Edition, December 24, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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