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.