Fitch Analysts Warn Of Dangers Of Rapidly Rising Interest Rates

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A gradual increase in interest rates could help U.S. life insurers, but a rapid “pop up” in rates would probably hurt them, according to two insurance rating analysts at Fitch Ratings Ltd.

Fitch and Lehman Brothers Inc., New York, recently responded to the dramatic shifts in U.S. interest rates by sponsoring a teleconference on the effects of rate changes on life insurance stocks.

Despite all the attention life insurers pay to the risk that insureds will die, insurers “suffer more from interest rate risk than from mortality risk,” Michael Barry, an analyst in Fitchs New York office, told investors who called in for the conference, according to a conference transcript.

Barry acknowledged that the kind of environment insurers survived in 2002 and early 2003a slow, steady decrease in rates during a low-rate environmentis painful for many insurers.

Because of the legally required minimum rates that insurance companies must pay on many annuities and insurance products, and the higher minimum rates that companies often promise to win business away from competitors, “the companies cant fully adjust their crediting rates to reflect the market declines,” Barry said. “The big risk at the end of the day is that we start to bump into the minimum rate guarantees and, possibly, can end up close to the situation that a lot of the Japanese companies found themselves in not that long ago.”

But Barry argued that a pop-up rate scenario would hurt life insurers even more.

Barry noted that New York insurance regulators ask life insurers to analyze how their businesses might perform in a pop-up scenario in which rates go up 3 percentage points in a single month, then level off.

A slow increase from todays low rates might help insurers increase the difference between the rates they are paying customers and the rates they earn on their own investments. But, in a pop-up rate scenario, fixed annuity and life policy “surrenders would certainly increase as market rates would be increasing faster than insurerscould increase their crediting rates,” Barry said.

Insurers would have to sell bonds at a loss to make good on obligations to the departing customers, and insurers that had tried to get higher rates of return by buying bonds with longer durations would lose more than holders of bonds with shorter durations, Barry said.

The forced bond sale “would lead to capital depletion,” Barry said. “To boot, the best assets typically are sold first under this type of scenario, leaving the remaining liabilities with lower quality asset support.”

Julie Burke, an analyst in Fitchs Chicago office, said assessing the vulnerability of a life insurer to changes in interest rates is difficult even for a rating analyst who has access to actuarial memoranda and other private documents.

“In our view, the best hedge is product diversity,” Burke said. “For instance, a company that writes singe-premium deferred annuities as well as a lot of single-premium immediate annuities has a natural interest rate hedge.”

If rates go up quickly, deferred individual annuities and traditional institutional stable-value products will be the riskiest products for insurers to have on their books, because investors will yank out their cash, Barry said.

Whole life and term life products should be safer, because the products are less sensitive to changes in interest rates, and the supporting investments are more geared toward long term returns, Barry said.

Fitch analysts also look at who an insurer has selling its products.

In some cases, insurers do better when many customers give up certain kinds of policies. But in cases when rapidly rising interest rates are depleting insurers capital, sticky customers are better, the analysts said.

“Products distributed through career agents tend to be much stickier than, lets say, products distributed through the wire houses,” Burke said.

Barry said plain vanilla risk-based capital ratios do a poor job of reflecting insurers vulnerability to changes in interest rates. About 10% of life insurers do another kind of analysis called “C3 phase-one testing” that gives more information, but insurers do not have to reveal the results of C3 phase-one testing to the public, he added.

Burke pointed out that mergers and acquisitions are putting more insurers in the arms of big, diversified companies with sophisticated risk-management teams. She said more companies are performing “stochastic” tests, which involve analyzing how companies might perform under a wide variety of randomly chosen conditions, rather than simply testing how companies might perform in a handful of what executives believe to be “typical scenarios.”

But Burke contended that few of the reports that life insurers file with the U.S. Securities and Exchange Commission disclose much detailed information about the products that the insurers sell, let alone the results of stochastic testing or C3 phase-one testing.

“To some degree, it is up to the investment community to try and demand the details,” Burke said.


Reproduced from National Underwriter Life & Health/Financial Services Edition, November 14, 2003. Copyright 2003 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.