Life insurers may finally start to get higher interest rates on their investments in corporate bonds, after years of waiting for the interest rate drought to end and rates to turn up.
Life insurers invest about $2.1 trillion of their $4.3 trillion in general account assets in corporate bonds, according to the American Council of Life Insurers.
Corporate bonds are now going through the worst selloff since about 2000, according to JPMorgan Chase & Co. bond index. The selloff is increasing the rates corporations have to pay to borrow money by issuing new bonds.
The shift means that life insurers can get higher rates when they buy newly issued bonds.
Bloomberg is reporting, however, that pension funds and overseas investors are still hungry for U.S. corporate bonds. That could limit how much interest rates will continue to rise.
How Bonds Work
When a corporation borrows money, it is, in effect, renting the money it’s borrowing.
A bond is a security that a corporation can use to borrow money. The interest rate the issuer pays on the bond is the price the corporation pays to rent money from the bond buyers.
Life insurers typically try to “match the duration of their bonds to their liabilities.” That means that life insurers try to buy bonds that will pay off about the same time the insurers will have to make insurance policy benefits payments and annuity contract payments.
When possible, insurers are long-term investors. They hold most of their bonds until the bonds mature.
Rising interest rates can hurt bond mutual funds and ordinary short-term investors that often sell bonds before the bonds mature. That’s because the higher interest rates available from the issuers of new bonds make the stream of income from older bonds, which pay a lower rate of interest, less valuable.
Rising rates will cut the reported value of life insurers’ bond holdings. Life insurers could also face actual cash losses in cases in which they sell bonds before the bonds mature.
If, however, a life insurer holds a bond until maturity, it should get all of the income it expected to get, unless the issuer defaults. The life insurer will face no actual losses on its existing bond holdings solely because of the increase in rates.
Meanwhile, life insurers will get higher rates on the new bonds they buy. That will help increase their total revenue.
The interest rates on bonds are especially important for life insurers because of the way life insurers operate.
At property-casualty insurers and health insurers, most of the cash used to pay claims comes from premium payments.
When a life insurer sells a product that may pay off far in the future, or may create an obligation to pay benefits over a long period of time, the cash used to make the payments usually comes partly from premium revenue and partly from earnings on invested assets.
Investment earnings are especially important for long-duration products such as long-term care insurance, long-term disability insurance and annuities.
All other things being equal, a 1 percentage point increase in bond rates could generate about $100 million in extra earnings on a $10 billion bond portfolio at a typical annuity issuer, or long-term care insurance issuer.
— Read AALTCI Explains Effects of Interest Rates on ThinkAdvisor.