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Ben Bernanke and You

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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.

Many companies have exited LTCI because of a combination of low lapses and low interest rates.

This experience has also driven a number of rate increase filings on legacy blocks and the introduction of newer LTC products.

In pricing and designing new products, the insurers are incorporating lessons learned on their older business. In evaluating the impact of a low-rate environment on an insurer, we note that it is important to consider the entire company and not just a portion of their assets and liabilities. While a block of business such as LTCI may come under pressure, other products may be less impacted.

If rates went even lower in the future, what would that do to financial statements reported in terms of the regulators’ statutory accounting rules and public companies’ Generally Accepted Accounting Principles (GAAP) rules?

If interest rates went even lower in the future, already low crediting rates for annuities and some life products, would get even closer to guaranteed minimums.

Many companies are already close to minimums; these insurers would experience negative spreads.

Long-term care insurance products, where low interest rates have caused almost all industry participants to either curtail their offerings or raise prices significantly would see its viability as a product likely up for discussion.

Hedging costs related to low interest rates would rise and impact variable annuity product pricing and profitability.

We would expect to see products with more limited guarantees and possibly shorter tails than we see today.

A lower interest rate environment could cause companies to accelerate either statutory reserve increases or GAAP deferred acquisition costs (DAC) writedowns or both.

On the asset side, investment portfolios could see a shift away from fixed-income assets to equity or real assets. If interest rates head too low for too long, companies may need to re-evaluate overall strategies given that the insurance company business model has generally relied on a target level of investment margins, which may no longer be achievable.

If rates went up 3 percentage points in a year, as they did back in the early 1990s, what would that do to LTCI operations?

A gradual rise of interest rates would be good news for insurers in general and LTCI writers specifically.

A rise in rates, while not providing instant relief would contribute to a profitability picture that would be improving. However, a sharp increase in rates would be less positive than a gradual uptick. For one, a sharp rise would cause market values of assets to decline significantly, which would cause unrealized losses.

If the level of policyholder surrenders on cash value products were to spike up, these unrealized losses could become crystallized, the classic disintermediation risk that life insurers face.

In addition, a sharp rise in rates could potentially mean that inflation, which has been dormant for many years, could return. As such, claim costs could rise.

A sharp rise in interest rates could potentially be de-stabilizing for the economy in general. With the 10 year treasury approximately 1.7% currently ( Aug. 9, 2012, end of day closing rate), a 3% rise would mean a tripling of the benchmark yield whose effects are hard to predict. Although interest rates rose by 6.75% in the 1979-1981 timeframe, interest rates were well in double digits at the time.

Why is it taking so long for the impact of low interest rates to show up significantly in insurance company financial results?

There are several reasons why it is taking so long for the impact of low interest rates to show up significantly in insurance company financial results.

For one, life insurance companies portfolios are of relatively long durations, which means that portfolio turnover in any given year represents only a relatively small portion of the portfolio. This means that much of the investment portfolio of insurers is earning new money rates of yesteryear when interest rates were higher.

Of course, low rates could trigger more prepayments and calls which could negatively impact investment income.

In addition, disciplined asset liability management practiced by many insurance companies helps immunize them from interest rate movements. We have also observed aggressive crediting rate management on the part of companies to lower interest credited to annuity contract holders as new money rates dip; this helps to mitigate spread compression.

Additionally, U.S. accounting both on the statutory and on the GAAP side promote delayed recognition of losses. On the statutory side, cash flow testing is very assumption-dependent and those assumptions are set by the companies; thus, on the whole, assumptions are typically not overly conservative.

On the GAAP side, mean reversion formulas for interest rates allow companies to use interest rate assumptions in future years that revert to historical means, which cushions the blow of current low interest rates as historical interest rates were much higher than those currently experienced.

Normal GAAP DAC unlocking also smoothes the impact over time.

By contrast, Canadian companies that report under CGAAP/IFRS accounting generally see the immediate impact of low interest rates since they essentially mark-to-market their liabilities every quarter; this also introduces much more volatility in their reported results, which can be difficult to interpret.


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