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.