Members of the long-term care (LTC) planning community celebrated last week when interest rates started to creep up out of the bowels of the Earth.
The Federal Open Market Committee (FOMC) said it was increasing the federal funds rate 0.25 percentage points, to 0.5 percent.
The Federal Reserve Board increased the federal discount rate 0.25 percentage points, to 1 percent.
Many agents, brokers and others tried to make a good show of acting as if they understood what that meant.
The American Association for Long-Term Care Insurance (AALTCI) put out a statement welcoming the rate news.
“Consumers want affordable options they can feel about, and rising interest rates will benefit both prices and the sense of financial stability,” Jesse Slome, AALTCI’s executive director, said in a statement.
So, why are Slome and other members of the LTCI community smiling about the rate increase?
For an explanation, read on.
1. What exactly are the FOMC’s federal funds rate and the Federal Reserve system’s discount rate?
The Federal Reserve system is a collection of giant government-chartered banks that manage the U.S. monetary system. The federal funds rate is the rate those giant banks charge each other for loans.
The federal discount rate is the rate the Fed charges commercial banks when they borrow money from the Fed. But commercial banks aren’t normally supposed to borrow money from the Fed.
2. Why do issuers of long-term care insurance (LTCI) care so much about interest rates?
Issuers of LTCI, long-term disability (LTD) insurance and other products with potentially long benefits durations, or benefits triggers that could occur far in the future get some of the money they pay out by investing premium revenue in high-grade corporate bonds and other classes of assets that state insurance regulators view as being safe.
Issuers of products with long-term obligations also use interest rates when deciding how big of a reserve they have to set aside to support the claims they’ve already decided to pay.
For issuers of LTCI and LTD products, managing portfolios in the low-rate environment of the past decade has been like trying to grow corn during a severe drought.
The impact has been even harder on issuers of LTCI, and individual disability insurance, because issuers of those products typically have less ability to change premiums than issuers of group LTD products do.
3. Why don’t LTCI issuers just invest in something that pays higher rates?
They try, but state insurance investment guidelines, which are based on standards developed by the National Association of Insurance Commissioners (NAIC), discourage the issuers from putting a big share their assets in stocks and other instruments viewed as being less dependable than high-grade bonds.
4. Why are corporate bond rates so important to insurers?
The state insurance investment guidelines treat high-grade corporate bonds about as kindly as government bonds, and the high-grade corporate bonds usually pay higher interest rates.
5. Do the federal funds rate and the federal discount rate have any direct effect on the rates that corporate bond issuers pay?
Maybe. Some economists say they do affect the corporate bond rates. Some say the views of the bond issuers and the appetites of the investors have a much bigger influence.
If big companies are too scared about the economy to borrow money to start big new projects, higher Federal Reserve rates might not do anything to increase the rates the corporate bonds pay.
6. If the rates insurers actually get went up 1 percentage point, what would that do?
In 2013, Slome cited an estimate from Claude Thau, an LTCI specialist, that a 1 percentage point increase in rates could generate about $100 million in extra earnings on a $10 billion bond portfolio at a typical U.S. LTCI issuer.
Slome noted at the time that LTCI issuers had about $40 billion in reserves backing the policies. He predicted, based on Thau’s rule of thumb, that a 1 percentage point increase in portfolio yields could bring the issuers about $400 million in extra revenue.
In 2012, in the group LTD market, which is also sensitive to interest rate assumptions, a chief financial officer (CFO) at one LTD issuer said a 0.25 percentage cut in interest rate assumptions would translate into a 2 percent to 3 percent increase in group disability insurance prices. Another CFO said a 0.25 percentage point rate cut would translate into a 2 percent increase in group disability prices.
Those figures imply that a 1 percentage point increase in rates could translate into an 8 percent to 12 percent rate decrease in group LTD premiums, or an equivalent increase in issuer profitability.
However, Slome is estimating that a 1 percentage point increase could translate into a 10 percent to 15 percent cut in LTCI premiums, or an equivalent increase in issuer profitability.
7. Then, what if rates went up 3 percentage points tomorrow? Wouldn’t that be swell?
Analysts at Fitch Ratings and other rating agencies that the kind of big, sudden increase in rates that occurred in the early 1990s could cause dangerous problems for life insurers’ overall operations.
A sudden increase might raise corporate bond rates, but it could weaken the finances of employers and consumers that have variable-rate debt; tempt consumers into moving assets parked in insurance products into bonds; and destabilize insurers that coped with low rates by locking money into low-rated assets with long durations.
8. Could a gradual, significant increase in rates help reduce LTCI prices?
Eventually, but — given that many LTCI issuers have been struggling to survive the interest rate drought by increasing premiums — they may be more likely to start out using higher portfolio yields to stabilize LTCI operations rather than to lower LTCI premiums.
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