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For life insurers, Fed’s rate hike is small step on a long road

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The Federal Reserve’s decision to boost short-term interest rates raises an intriguing question among industry-watchers: To what degree might the rate hike impact life insurers’ investments and product orientation in 2016?

The short answer: not much. But if short- and long-term interest rates continue to rise gradually over a period of years, life insurers’ cash flow and profitability should measurably improve. And that could translate to more attractive products for life insurance sales professionals and their clients.

Liftoff from zero

That bright future appears, for now, far off. The Fed’s December 16 increase of the benchmark Federal Funds rate by just 25 basis points, coming after a 9-year hiatus, is too small to have a significant effect, say ratings analysts who track the companies.

“The [rate hike] hardly constitutes a tectonic shift in the marketplace,” says Deep Banerjee, a director at Standard & Poor’s. “We won’t foresee much change near-term in life insurers’ investment yields.”

Neil Strauss, an analyst and vice president of the Financial Institutions Group at Moody’s Investor Service, agrees. “The interest rate rise is a small increase, though directionally, is good for the industry,” he says. “But in terms of order of magnitude, it’s a minor improvement.”

Of particular interest to life insurers are “spread compression” yields: the difference between the minimum guaranteed rates of return paid consumers (e.g., holders of fixed income annuities) versus what the companies earn on their own investments.

These spreads have been tightening in recent years as a result of declining returns (and thus profitability) on insurers’ traditional investments in corporate bonds. The Fed’s action, said Banerjee, will only marginally alleviate financial pressures the carriers face on this issue.

To boot, any gains have to be weighed against a secondary effect of the rise: a commensurate decline in bond prices. On insurers’ balance sheets, this drop in value is indicated as an unrealized loss; assuming continuing rate increases, further losses could strain the companies’ ability to maintain adequate capital reserves.

But, Banerjee notes, life insurers’ capital adequacy remains “strong” relative to the investment risk on their books. The carriers remain overwhelmingly invested in investment grade (e.g., AAA) corporate bonds, highly liquid assets that can easily be converted to cash in a financial crunch.

With further interest rate increases on the horizon — the Fed expects to continue to ratchet up short-term rates through 2016 — life insurers might feel less pressure to bet on higher risk, illiquid assets to boost yields. Among them: emerging market debt, private equity, hedge funds, commercial mortgages and other asset-backed securities to which insurers have been directing more of their investment dollars since the 2007-2009 financial crisis.

A 2015 Conning study, “Life Insurance Industry Investments: The Search for Yield Runs Dry,” observes that between 2010 and 2014, life insurers’ allocations to these investment alternatives increased, including mortgages (to 11.3 percent of investable assets in 2014 from 10.1 percent), commercial mortgage-backed securities (5.1 percent in 2014 versus 4.8 percent in 2010) and non-real estate, asset-backed securities (6.7 percent versus 5.6 percent). 

These portfolio changes have yield gains, most especially between 2013 and 2014. During the one-year period, the industry’s investable assets increased by 4.0 percent or $130 billion, attaining $3.4 trillion. The rise exceeded the 2.1 percent annual growth rate of all sector assets.

Given these positive results, further marginal increases in the interbank Federal Funds rate — by, say, 25 basis points each quarter through year-end 2016 — is unlikely to much alter insurers’ investment orientation or profitability absent an uptick in long-term interest rates, such as yields on 10-year Treasury notes.

Long-term yields are key

 “It’s not that exciting a story,” says Banerjee. “The [Dec. 16] rate may lead to small changes in insurers’ investment focus. What’s more important for life insurers are long-term interest rates, as they both hold and invest in long-term assets.”

Adds Moody’s Strauss: “Insurers will be looking at long-term yields before they make wholesale changes to their investments or products.”

And the direction of long-term rates, which have been on the decline worldwide for three decades, is only partly dependent on monetary policy. Other factors — domestic and foreign fiscal policies, shifts in inflation risk, private-sector deleveraging, declines in productivity growth rates, changing demographics and a glut in savings worldwide — also influence long-term rates. Reversing the downward direction of rates may thus take years.

When they do rise, long-term rates may not achieve the levels of decades past. A July 2015 report of the Council of Economic Advisors, which reports to President Obama, suggests that long-term interest rates may settle at a “lower equilibrium” than existed prior to 1985. The reason: structural changes to the U.S. and global economies.

“[E]xpected future long-term interest rates a decade from now have…fallen substantially from what was expected by forecasters, or indicated by market-forward rates, a decade or two ago, states the report, Long-term interest rates: a survey. “Determining how long low long-term interest rates will persist and whether they will settle at a lower level than previously expected requires an evaluation of the reasons they are low today.

“While there is no definitive answer to this question, many factors suggest that long-run equilibrium long-term interest rates have fallen,” the report adds.

Whether lower long-term rates are indeed here for the long-run will partly depend on the Fed’s future moves. If, say, the economy becomes overheated, boosting the inflation rate to undesirably high levels, then the central bank may feel compelled to significantly raise short-term rates ­­— and over a short period.

To the extent the bump-up boosts long-term rates, that’s good for life insurers’ investment portfolios. But a fast ratcheting up also poses a problem, known as disintermediation or asset-liability management 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.

Max Rudolph, principal of Rudolph Financial Consulting and an author of a Society of Actuaries report, Transition to a High Interest Rate Environment, warns that a rapid rise in rates of 5 percent or more 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.

S&P’s Banerjee agrees. “If suddenly, interest rates were to spike by 200 or 300 basis points, unrealized losses could become pretty significant. Consumers might wish to take their business elsewhere. That would not be a good thing for insurers.”

Gradual is good

A better glide path would be one the Fed appears to have settled on: a slow rise in rates through 2016 and (potentially) beyond.

The gradual increases would allow life insurers adequate time to adjust product pricing, guarantees and features to reflect new market conditions. And they would feel less pressure to compete on crediting rates paid to policyholders.

Says Banerjee: “A gradual increase is a good thing, though it will take a longer time for life insurers to get to a ‘normal’ interest rate — say, 4 percent or a bit higher paid on 10-year Treasury notes. We don’t expect this anytime soon, but a slow uptick is definitely better than a spike.”

A steady increase in rates, combined with other positive trends (such as rising life expectancies), should lead to more attractive solutions for agents and advisors. Chief among them: interest-sensitive life insurance products and annuities structured to maximize retirement income for policyholders.

“Sales of interest-sensitive products will increase, which means that movement of interest rates will have a bigger impact on life insurers than they did 10 years back,” says Banerjee.

See also:

The 7 biggest insurance stories of 2015

Fed raised rates without a hitch, and it only took $105 billion

Billionaire investor Wilbur Ross says Fed ‘fiddled too long’

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

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