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Higher interest rates: Don’t wish for too much, too fast

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There’s broad consensus that the Federal Reserve will deliver an interest rate hike at its December 16 policy meeting, and that life insurers will at long last get some relief from historically low yields. Often not discussed among industry-watchers, however, are the risks insurers face in a rising interest rate environment, specifically one where rates ratchet up unexpectedly fast over a short period.

This is a scenario the companies need to factor into their contingency plans. Because if rates spike at a clip for which the carriers are ill-prepared, they may face disintermediation or asset-liability management (ALM) risk: the possibility that policyholders surrender all or part of their contracts to secure better crediting rates in alternative products. And that cash-out may require insurers to sell assets at a loss, placing them at risk of insolvency.

Think this train of events unlikely? Think again. In a July 2015, report, “Transition to a High Interest Rate Environment,” the Society of Actuaries (SOA) identifies a faster-than-expected hike in rates as a real prospect — and one that should be of genuine concern to the carriers.

“For…an insurer with material surrenders, a spike in interest rates could threaten solvency,” the report states. “Some insurers may become insolvent due to policyholder disintermediation, asset losses and ALM/liquidity issues, and it could happen very quickly and unexpectedly.”

Max Rudolph, principal of Rudolph Financial Consulting and one of the SOA report’s authors, emphasized the point in a phone interview with me. Should rates move up quickly, he said, there’s a potential mismatch between assets and liabilities, where cash flows underpinning the former are of shorter duration than they are for the latter.

Such a mismatch can put insurers’ balance sheets under greater pressure. A fast rise in rates by 5 percent or more, Rudolph warns, could trigger policy lapses and capital losses, the severity depending in part on the degree to which the insurers’ blocks of business are interest rate-sensitive.

The impact will be less pronounced in respect to universal life and indexed universal life products. The reason: policyholders keen to buy products with higher crediting rates may be dissuaded by premiums that are too expensive because of their age and/or a deterioration in their health.

At the other of the spectrum are fixed deferred annuities, which are exposed to the highest disintermediation risk. As policy holders surrender their contracts amid rising rates, the resulting capital losses, Rudolph cautions, could be “very stressful for an insurance company.”

Those carriers that manage to survive this “initial test of solvency” can start afresh with products better attuned to higher rates.

The $64,000 question is how many might not. Much will depend on how risky and liquid the insurers’ investments are. As the SOA report notes, “[H]olding high-risk assets may increase short-term profitability but increases longer-term liquidity and solvency risks.”

Findings of a new study from Fitch Ratings are, in light of the SOA report, not reassuring. The report cites a shift by the carriers between 2007 and 2014 to corporate securities from poorer-performing structured securities. Over the same seven-year period, the carriers increased their capital exposure to higher-risk corporate bonds.

In tandem with these shifts, the companies also modestly increased holdings of private placement securities relative to publicly traded bonds. These changes lowered liquidity of the insurers’ corporate bond portfolio. Meanwhile, the quality of the carriers’ stated regulatory capital also dipped.

Result: a heightened exposure to corporate securities, as well as lower credit quality and liquidity, than the insurers had before the 2007-2009 economic downturn.

Add to these concerns one another we address in this issue’s “2015 Rogue’s Gallery:” the shift by some 70 product manufacturers of an estimated $440 billion in liabilities to captive reinsurance companies, also known as special purpose vehicles. Because the ceded liabilities are often not matched by collateral assets sufficient to guard against default, insurers that established the captives are at risk of financial insolvency.

All of this is undoubtedly keeping more than a few life insurer CFOs up at night, as well as merger-and-acquisition specialists on high alert for the next prospective deal. For the very thing insurers have long been yearning — higher interest rates — could ironically result in an unprecedented wave of buyouts of distressed companies.