LifeHealthPro Senior Editor Warren S. Hersch recently interviewed Terence Martin, director of life annuity research at Conning & Co., a provider of asset management, risk and capital management solutions and insurance research. The interview explored the impact of the current rate environment on life insurers and the outlook for both in 2015. The following are excerpts.
Hersch: How do you assess the interest rate impact on life insurers to date? What do you expect going forward.
Martin: We’re a expecting a continuing drop in life insurers’ book yields — the companies’ [interest rate-dependent] net investment income divided by average general account assets — before an uptick in 2016. Our current projection, based on internal modeling and a survey of economic forecasters by the Federal Reserve Bank of Philadelphia, shows insurers’ average book yield dropping to 4.56 percent in 2014 from 4.63 percent in 2013, then rising to 4.61 percent by year-end 2016.
The Fed impacts short-term interest rates through its discount rate for financial institutions. But the market affects rates of long-term bonds — the main investment vehicle of life insurers. Reproducing historically high yields on these bonds will require sustained economic growth.
Also, there is a lot of inertia in life insurers’ portfolios because their invested bonds tend to have long maturity periods. Like a super tanker, it takes a long time to turn around the yields on these vehicles.
Hersch: How would you characterize the composition of life insurers’ portfolios? Just how much is invested in bonds? And how does the portfolio make-up differ from prior years?
Martin: The portfolios consist overwhelmingly of fixed income assets: about 80 percent bonds, mostly corporate. Real estate and mortgages comprise an additional 10 percent. Another 8 percent or so comprises alternative vehicles, such commodities, real estate investment trusts or REITs, plus equities. Cash represents an additional 2 percent.
These percentages have been fairly stable over time, especially the bond component. However, insurers have been reducing direct holdings of real estate in favor of REITs because REITs are more liquid.
Given life insurers’ desire for higher book yields, one might ask why they don’t invest more in alternative investments and equities. In fact, there has been some movement in this direction, but insurers incur a risk-based capital (RBC) charge when they invest less safe assets. For high quality AAA bonds, the capital they’re required to set aside is much smaller than if they invest in lower grade bonds or common stock. When they go into riskier assets, they must set aside more capital based on an RBC formula.
Hersch: How do anticipate their portfolios changing as interest rates rise or fall?
Martin: If interest rates rise, then I would expect insurers to invest more in higher grade corporate bonds — shifting, for example, from BBB to AA bonds; and from AA to AAA bonds. Bonds below investment grade — that is, below BBB — generally make up a very small portion of insurers’ portfolios. Insurers don’t like to allocate funds to these lower-grade, higher-yielding vehicles because, again, that would entail an RBC charge.
Hersch: What impact do you expect prevailing interest rates will have on product sales for insurance and financial service professionals?
Martin: If interest rates rise, then insurers may be able to increase their crediting rates on policies, making them more attractive than other financial instruments. The biggest beneficiaries of a rise in rate would be providers of fixed annuities and stand-alone long-term care products, which have long suffered from the low interest rate environment. Manufacturers of linked-benefit products — universal life insurance and annuities that come with a long-term rider — would also benefit.
Hersch: Have life insurers generally done well in calibrating the premiums and product guarantees to interest rates in recent years? Or have you found the structuring of policies questionable?
Martin: Insurers learned a lot from the 2007-2009 economic downturn. They’ve re-priced new products and phased out once-generous product guarantees. However, many carriers are still supporting older blocks of business that offer rich product benefits and, thus, depress the bottom line of balance sheets.
If interest rates are restored to pre-crisis levels, I don’t believe that insurers will reinstitute the old guarantees. They won’t want to subject themselves to the same risk. Premiums may decline a bit and the product guarantees may be a bit more generous, but they won’t be what they were formerly.
Hersch: So therefore sales will not return to the pre-crisis levels?
Martin: Not necessarily. Insurers are looking for additional product innovations that would make their policies more attractive relative to other investments. One avenue for future growth could come in the form of new varieties of contingent deferred annuities: hybrid products, such as mutual funds or managed accounts, that will offer account holders a guaranteed lifetime income stream.
I also foresee life insurers establishing or expanding non-traditional offerings, such as pension risk transfer; and I expect they will more aggressively market traditional insurance products in promising overseas markets.
Here in the U.S., we’re seeing a bifurcation of the market: Advisors pursuing the high net worth; and insurers are expanding direct-to-consumer marketing initiatives to win over middle market prospects who are interested in smaller policies. To that end, they’re pursuing technology initiatives for consumers — cell phone apps, self-service web portals, online robo-advice and the like — that can ease sales for agents and brokers.
Hersch: What do you identify as the key opportunities and challenges for life insurers in 2015?
Martin: In respect to interest rates, a gradual rise in interest rates would be ideal. Continuing low rates is a long-term problem. A big, sudden spike in rates would also be a problem. Everyone wants a nice, steady, predictable climb.
The insurance industry really needs to do a better job reaching out to the middle market consumer. Every year, we at Conning calculate a life insurance protection gap: the amount by which the public is underinsured. As of 2014, a closing of the insurance gap would increase the in-force policy number by 50 percent. That represents a huge opportunity for life insurers.