It is a “trillion-dollar question:” When will the Federal Reserve Board change its monetary policy and allow interest rates to edge up from their current scrapping-the-bottom-of-the-barrel levels? That’s how Robert Benmosche, president and CEO of American International Group, described the wrenching challenge driving the insurance world, whether it be carriers, agents, customers, investors, regulators, marketing experts or rating agencies.
Ratings agencies feel the same. In a recent report, analysts at Moody’s Investors Service called it a “key risk” in the U.S. life insurance sector. “We believe that life insurers are overly optimistic” in dealing with the issue, citing as one reason the fact that U.S. accounting standards permit the deferral of the recognition of changing economic conditions, such as low interest rates.
The Moody’s report also cites other factors that lead them to believe life insurers have been playing down the risk. Factors such as life insurers’ “robust earnings growth expectations (even relative to historical levels for benign periods) under an adverse macroeconomic environment and past underestimation of potential tail risk (e.g., variable annuities with guaranteed benefits and long term care insurance).”
The report also notes that as rates have fallen to unprecedented levels and remained there longer than expected, investor concern has intensified. This worrisome attitude has led to depressed stock valuations and wider credit spreads relative to non-financial sectors.
“We believe that if rates remain at current levels beyond 2015, there would be significant earnings charges and loss of capital with many rating downgrades,” Moody’s reports. An extended period of low interest rates would also lead not only to significantly lower investment income, but also to higher statutory reserve requirements and meaningful DAC write-downs (on GAAP financials), weakening companies’ profitability.
According to the report, the most affected insurers would be those that have sizable exposure to fixed-rate immediate and deferred annuities; universal life and interest sensitive insurance policies with high minimum crediting rates; variable annuities with lifetime guaranteed income benefits; long-term care; and long-term disability.
In a study conducted last fall, Conning, Inc. said that on June 1, 2012, the yield on the benchmark 10-year Treasury bond reached a 60-year low, falling to 1.44%. The report said the European debt crisis had precipitated this decline as foreign investors continue to seek the perceived safety of the U.S. bond market.
This is not only an issue for foreign and domestic investors; it is also a problem for property-casualty insurers. Since 1997, the book yield for property-casualty insurers has fallen from 5.7% to 3.7% at year-end 2011, a decline of 200 basis points, according to Conning.
Life insurers haven’t fared much better. Their book yield has dropped from 7.3% 1997 to 5.0% at year-end 2011, a decline of 230 basis points. (These book yields reflect net investment income as a percentage of average net invested assets reported for the U.S. property-casualty and life industries, respectively.)
This falling rate environment has created serious challenges for the insurance industry, which depends on investment returns to support the profitability of its products. Insurance companies must plan for declines in investment yield and income, but they must also balance the effects of a return to normal interest rates. And this is no small task. Balance sheet interactions between assets and liabilities create a complex challenge.
Benmosche touched on just that in his June 4 comments on the CNBC Newsmakers program. He warned that a hike in interest rateswhich some argue would fix the problem in one fell swoopwould in reality create a disintermediation issue, with people leaving one annuity, depending upon penalties, to go to another.
“Just like a CD, you leave the bank, you have a CD, your rates are going up, you may choose to pay the penalty and move your money,” Benmosche said. “And so that’s where rates at some point in time could be a negative for the insurance company, but I think for the first 100 to 200 basis points, it’s going to be a big positive not only for AIG, which has a big fixed annuity block, a life insurance block, but it’s also going to help most insurance companies.”
As to the timing by the Fed that would raise rates, he believes that will be when the Fed decides the job creation is there. “Look, one of the problems of job creation is you have many people who are eligible for or should have or normally would have been required to retire that are now worried about outliving their income, and so they’re not giving up their jobs and that’s sort of holding back the openings that a lot of young people could fill.” So, he said, “you’ve got to see that moving along a little bit better, see job creation and unemployment come down.”
In another recent report, Moody’s said a baseline economic scenario calls for a sluggish recovery and interest rates to increase slowly, but a plausible — and less likely — downside scenario would see stagnation and protracted low interest rates, reminiscent of Japan’s experience since the mid-1990s.
In its annual report to Congress about insurance, released June 12, the Treasury Department also voiced concern about the issue, stating that if the interest rate policy put in place by the Federal Reserve Board stays in place long term, it could severely affect the profitability of the U.S. insurance sector. And there’s a lot at stake.
The report says the life/health insurance sector posted record net premiums of $645 billion and net income of $40.9 billion for 2012.
These profits could be affected, however, if the Fed’s policy of ultra-low interest rates continues. The report also echoes Benmosche’s concerns: that a decision to raise rates also poses risks for insurers by, for example, increasing unrealized losses in insurers’ fixed-income investments.
How to Cope
While the Moody’s report voiced concern over the implications of sustained lower interest rates, there have been clear signs recently that insurers are making product changes in response to the low interest rate environment, as in the case of MetLife, which redesigned its variable annuity products, reducing the roll-up rate.
MetLife responded by first shifting its U.S. business to focus on more profitable products. It did so by redesigning its variable annuity products, reducing the roll-up rate and the withdrawal rate. Several weeks later, it announced plans to merge its three U.S. life insurers and a Cayman Islands-based reinsurance captive “to create a larger, well capitalized U.S. life company.”
MetLife is one of least five large life insurers that have advised annuity owners over the last 16 months that they are either not accepting or restricting additional money for older VA policies with guaranty riders whose yields exceed six percent.
Steven Kandarian, MetLife chairman and CEO, said the company is also significantly reducing its footprint in the VA market, from a high of $28.4 billion in 2011, where it was rated No. 1 in the market, to $17.7 billion in 2012, to an estimated range of $10 to 11 billion for 2013.