With U.S.Treasury Secretary Tim Geithner due to address the House Financial Services Committee tomorrow, July 25, on the annual report of the Financial Stability Oversight Council (FSOC), a Dodd-Frank Act requirement, expect some cautionary words about the health of the insurance industry and concerns surrounding the euro.
The low interest rate environment poses a significant challenge for life insurers with sizable blocks of liabilities with promised interest rate guarantees found in annuities or universal life insurance policies, the recently-released annual report written by FSOC members warns.
“The low interest rate environment has proved challenging for life insurers to generate sufficient investment returns to meet high guaranteed benefits promised in prior years,” the FSOC report stated.
Indeed, this is why the regulatory concern in some states over adequate life insurer reserve levels pursuant to Actuarial Guideline 38 applying to universal life with secondary guarantees (ULSG) is not just a small-screen issue.
The life insurance industry has reduced its minimum guarantees over time, but products sold when interest rates were higher represent a continued drag on profits, the FSOC notes.
The FSOC is made up 10 voting members and five nonvoting members and brings together the expertise of federal financial regulators from the head of agencies such as the Securities and Exchange Commission (Mary Schapiro), the Federal Reserve Board (Ben Bernanke) the Federal Deposit Insurance Corp. (Martin Gruenberg), the Commodity Futures Trading Commission (Gary Gensler) and state regulators (Missouri insurance commissioner John Huff), and an insurance expert appointed by the President (Roy Woodall). Only the voting members signed the annual report.
It is true that minimum guaranteed returns are falling–the share of life and annuity product account values subject to a minimum guaranteed rate of return of 5% or higher fell from 20% to 10% over the 2006-2010 period, according to the report.
However, more than 40 percent of account values were still subject to a minimum guaranteed rate of return of 3.5% or higher in 2010.
Life insurers have exited selected markets due to the inability to meet the minimum guaranteed returns associated with the underlying products in this low rate environment. Of note, life insurers have increased their use of non-traditional investments, such as hedge funds and private equity, perhaps as a response to the low interest rates that currently prevail.
Another area where life insurers have increased activity now is in funding new commercial mortgages.
Life insurers funded roughly 25% of new commercial mortgages in 2011, compared to 10% in 2007.
The euro uncertainty is also big focus of the FSOC report.
The FSOC noted that while direct exposure of U.S. institutions to the most stressed euro area countries appear to be low, U.S. banks, money market funds and the insurance industry have indirect exposures through other non-periphery countries and through asset markets.
“This generates heightened uncertainty about the extent to which evolving conditions could spill over to U.S. markets and institutions,” the report stated.
The FSOC also expressed concern about potential yield-chasing by insurers.
“The tendency to reach for yield may be especially pronounced for entities such as pension funds or insurance companies that face a stream of quasi-fixed nominal liabilities. For example, the investment yield for life insurers in aggregate is only around 1.1 percentage points above the minimum yield needed to maintain policyholder reserves, leaving these insurers with a relatively small margin of error…”
But, the FSOC added, “we do not see much evidence of such behaviors currently.”
But the FSOC will be watching “ indicators of such behaviors should be watched carefully, including leverage, contractual terms, borrower characteristics, the use of levered instruments for funding, issuance of “covenant lite” loans, and the rate of original issue, CCC-rated high-yield bonds.
There is even concern if the low interest rates go up too rapidly, which could be disruptive.
“For example, interest rates could increase rapidly following a loss in investor confidence in the sustainability of U.S. fiscal policy. It is unclear how well prepared fixed income markets are to the possibility of such rapid interest rate movements. Those especially vulnerable would be market participants with highly leveraged carry-trade positions,” the FSOC cautioned.
In property casualty, the FSOC noted that this sector faced historically higher catastrophe losses that impeded performance.
Remarkably, property and casualty insurers were pressured by large catastrophe losses in 2011.
Insured catastrophe losses were $33.6 billion in 2011, 135% higher than in 2010 and exceeded only by the extraordinary losses associated with Hurricane Katrina in 2005.
On a brighter note, despite a substantial net decline in income in 2011, capital levels within the insurance industry improved, according to the FSOC.
Property and casualty insurers faced historically higher catastrophe losses that impeded performance, the FSOC stated.