Ben Bernanke and You

Conspiracy theorists know that the Federal Reserve System is something that works with Queen Elizabeth to sell cocaine for the crew that has built an underground tunnel from Washington to Denver, keeps a room full of space aliens in jars in New Mexico, and caused  the earthquake that shook up the Mid-Atlantic states last summer.

Most of the rest of us know that the Fed has something to do with money, inflation and whether the announcers on CNBC and Bloomberg look cheerful or stern.

The Federal Reserve Board of Governors is actually a body that oversees a group of 12 regional Federal Reserve banks. The board and the system are supposed to try to manage the supply of money, keep employment as high as possible, keep inflation low, and keep long-term interest rates moderate.

The credit analysts on the U.S. life insurance team at Moody’s Investors Service, New York, are some of the people who really know what the Fed is, how it works, and why its actions are of interest to long-term care insurance (LTCI) carriers and other carriers.

Three of the analysts — Scott Robinson, a senior vice president; Shachar Gonen, an assistant vice president and analyst; and Neil Strauss, a vice president and senior credit officer — recently participated in an e-mail interview focusing on why Fed efforts to hold interest rates down are making life challenging for insurance company portfolio managers. The following is a lightly edited version of their answers.

What’s going on with the interest rates in general?

In the third quarter of 2011, the 10-year US Treasury rate dropped from 3% to near 2% and remained at those levels until May 2012. From that point, the 10-year Treasury continued to decline reaching historically low levels below 1.5% today.

Corporate-issued debt would typically have higher bond yields than treasuries owing to the increased risk over the U.S. government. In general, they have been following a similar movement as treasuries. The spread between yields on long-term average corporate bonds and comparable treasuries is currently near 150 basis points — or 150 hundredths of a percentage point. The high-yield bond spread is wider at 653 basis points as of the end of the second quarter of 2012.

At this point, what kinds of assets do life and health insurers really invest in?

Life insurance companies invest premiums and deposits in order to pay any ultimate policy payments, cover expenses, and eventually earn a return.

The majority of investment holdings are fixed-income securities, which represent approximately 80% of their cash & invested assets.

The fixed-income securities include corporate bonds, structured securities (RMBS, ABS, CMBS, etc.) and US government/sovereign securities which represent approximately 45%, 20%, and 15%, respectively, of cash & invested assets.

The majority of these fixed-income securities would have investment-grade ratings with a small percentage (about 5%) of below investment-grade holdings. U.S. life insurers’ investment portfolios typically have an average rating quality in the A to Baa range (low end of investment-grade ratings).

Life insurers also hold commercial mortgage loans (CMLs), which represent approximately 10% of cash and invested assets. The remainder of the holdings would be a few percent in each of real estate investments, cash and short-term investments, common stocks, and other securities.

In general, health insurers have similar investment portfolios to life insurance companies, however, there are some minor differences. Most health insurers do not hold CML and the exposures to structured securities and common stock equity securities are typically smaller than for life insurers.

From the rating analysts’ standpoint, do insurers with long-term care operations tend to put the assets backing the LTCI operations in separate categories that the analysts can look at separately, or lump the LTCI assets in with everything else?

Life insurers may segment investments into different categories or accounts in order to internally track and match insurance liabilities.

Moody’s does not typically look at the specific assets supporting LTCI liabilities (which pose minimal liquidity risk). Rather, Moody’s generally looks at the overall asset/liability management of the company at the general account level, with closer attention paid to large liability payments associated with institutional investment products, which can create liquidity strain on a company’s resources if not well-matched.

Moody’s also evaluates the credit exposure of an insurer’s aggregate investment holdings and determines an estimate of economic losses under a mild stress and a severe stress scenario. These loss estimates are influenced by the specific asset class allocations of the insurer.

Companies generally manage the duration of the assets to that of their liabilities and specifically for LTCI, they seek to acquire very long duration assets. However, because the duration of LTCI liabilities is very long, companies are exposed to reinvestment risk. If rates continue to remain low, profitability would be pressured.

So, how are rates on the assets backing the LTCI blocks (or general life/health blocks, if that’s what you can see) doing?

Portfolio yields are declining slowly (by about 15 to 25 basis points per year) as companies reinvest cash flows in lower yielding investments. For some companies, interest rate swaps are helping to mitigate the rate compression.

Are the insurers with LTC operations hedging against shifts in interest rates? If so, about how much are they hedging, and how does the hedging seem to be working?

Some insurers are hedging against a low-rate environment, although it may be executed for the overall portfolio as a “macro hedge”, not associated with a specific line of business like LTCI. While these hedges buffer investment returns, it is not fully offsetting the reduced yields on investments.

How is that rate performance affecting the LTCI carriers?

The low-rate environment is adversely impacting insurers, especially those with long-duration liabilities.