The entryway to Moody's offices in New York, taken around 2016 (Photo: Allison Bell/ALM)

Many U.S. life insurers are coping with low interest rates by investing in more lower-rated, higher-paying bonds and notes, and that strategy could backfire if the economy tanks, according to a new analysis from Moody’s Investors Service.

(Related: Regulators Could Help Life Insurers Buy More Stock)

Moody’s rating analysts came up with their own, rough, life insurer shock test by seeing what might happen to the insurers’ bond portfolios, and risk-based capital (RBC) levels, if bonds performed as poorly as they did during the 2001-2002 downturn.

In 2001-2002 Repeat scenario, the median issuer’s RBC rating would fall about 15%, the analysts estimate.

That means half of the issuers would face declines less than or equal to 15%, and half would face declines of at least 15%.

But “insurers with a high proportion of securities at the lower end of A-rating and Baa-rating are most susceptible to RBC ratio declines,” the analysts write.

Life Insurer Investment Basics

A bond is a security that a company or other issuer uses to borrow money.

Analysts often refer to “fixed-income securities,” rather than to bonds, because, technically, a bond is a security with a term of more than 10 years.

A note is a debt security with a term of one to 10 years.

Life insurers also invest in some types of instruments that are lumped in under the “fixed-income investment” heading.

As a rating agency, Moody’s is one of a handful of organizations that “rate” fixed-income securities, meaning that they decide how safe or risky the borrowers are. Borrowers with higher credit ratings, that look as if they’re more likely to make their payments, pay lower rates to borrow money; borrowers with lower ratings, that look more likely to default, pay higher rates.

Moody’s also give life insurers financial strength ratings. Those ratings show how likely Moody’s thinks life insurers are to make good on insurance and annuity obligations.

For life insurers, the borrower ratings are important, too, because life insurers use huge portfolios of fixed-income securities to support life insurance, long-term disability insurance, long-term care insurance and annuity obligations.

Moody’s rates only a small number of the biggest life and annuity providers, but it says the U.S. life insurers that it does rate have about $1.6 trillion in fixed-income security investments.

Regulators use their own indicator, the RBC ratio, to show roughly how strong an insurance company appears to be. A company with an RBC ratio of just 100% is supposed to take action to improve its RBC. Most insurers try to keep their “company action level” RBC ratios over 200%.

At the end of 2018, half of the U.S. life insurers that Moody’s rates had an RBC ratio at or under 447%, and half had an RBC ratio that was at or higher than 447%.

The 2001-2002 Repeat Scenario

RBC ratios depend partly on the ratings of the fixed-income scenarios in a life insurers’ investment portfolio. Life insurers get more of an RBC ratio boost from higher-rated, “investment grade” securities than from the lower-rated securities commonly known as “junk bonds.”

If the economy did very poorly, and many borrowers suffered rating downgrades, the resulting fixed-income securities issuer migration into the junk bond category could hurt life insurers’ RBC ratios, the Moody’s analysts write.

Moody’s analysts found that rating migration could cause the rated insurers’ median RBC ratio to fall to 378%, from 447%, with a range of 159% to 666%.

The number of rated insurers with RBC ratios under 300% could increase to 11, from five today, according to the Moody’s analysis.

Even if, in a severe 2001-2002 Repeat scenario, the median RBC ratio of the life insurers that Moody’s rates fell 15%, the typical rated life insurer “would still remain well-capitalized relative to regulatory requirements,” the analysts say.

The companies with larger holdings of investment-grade securities near the cutoff between investment-grade status and junk bond status could suffer, however, because those securities are more likely to move from the investment-grade category to the junk bond category, according to the Moody’s analysts.

— Read 3 Hot Sources of Life and Annuity Sector Terror, on ThinkAdvisor.

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