What You Need to Know
- The author says mortality impact due to COVID-19 for people with life insurance has been manageable.
- He believes most life insurers seem to have started with enough of a capital buffer to cope with the recession.
- He says sponsors must be vigilant and assess the safety of insurers before placing business with them.
Plan sponsors embarking on an annuity purchase face additional uncertainty and risks due to the implications of COVID-19. Transactions are continuing and there are no current solvency concerns, however awareness of market conditions and performing due diligence of insurance providers takes on additional importance.
Over the last decade, de-risking a pension plan through the use of an annuity buyout has become prevalent. In 2014, total buyout sales were under $10B; in 2020 they had skyrocketed to an estimated $25 billion. Pension plan sponsors that have offloaded liabilities to insurers through this strategy have saved on administrative costs and lowered funded status risk. In addition to buyouts as a de-risking strategy, there has also been an uptick in the number of plan terminations which ultimately end in a buyout contract. It’s clear that annuity buyouts have served as a valuable strategy for pension plan sponsors.
Insurers participating in the pension risk transfer (PRT) market started 2020 from a strong position. They are heavily regulated companies that maintain a significant buffer of assets to weather the adverse conditions we are now seeing. They are not leveraged in the same extent as the banking sector. We now examine the key drivers through 2020 and beyond on insurer solvency which are the impact of high death claims, the deterioration of investment portfolios in the economic environment, and
lower interest rates.
Impact of Death Claims Remains Manageable
Most PRT providers offer life insurance policies which have experienced higher payouts due to deaths associated with COVID-19. The good news here from the insurer’s perspective is that the number of deaths in the insured population, which is typically made up of people ages 35 to 65, has been manageable. As one PRT provider put it, “In terms of the financial impact, compared to the death scenarios we run, this isn’t a pandemic.”
See the COVID-19 mortality chart in the slideshow area above.
About 80% of COVID-19 deaths have been in the 65-year-and-older categories. People in these groups are not generally covered by life insurance policies.
To put death claims in perspective, as of Jan. 27, 2021, there had been 65,000 deaths in the United States attributable to COVID-19 in the 35-65 age group, and a total of 727,000 deaths due to all causes in the same group since the beginning of 2020. This equates to approximately an increase of about 10% in death rates directly due to COVID-19.
The pandemic will generate some losses for life insurers but is materially below the severity that insurers reserve for — which tend to be more like multiples of the average death rate. Another consideration is that poorer socio-economic groups have seen significantly higher rates of COVID-19 deaths, yet life insurers have not been as exposed to claims here as these groups have smaller policies in force, if any life insurance at all. Insurers also reinsure pandemic risks away meaning that they will not experience the full force of any claims on their balance sheets beyond a certain level in any case.
Finally, the virus has a higher mortality rate in old age so there may be, sadly, some benefit to insurers with large annuity books who no longer have to pay out annuities to these individuals.
Impact of a Recession on Insurers’ Investment Portfolios
This is the area that potentially has the greatest negative impact to PRT providers. Despite global fiscal and monetary intervention, the world is in a recession. Approaching one year after restrictions began, it remains uncertain how quickly economic activity will resume to normal.
The majority of insurance company failures historically have arisen due to losses incurred on investment portfolios. Although the quality of insurers’ portfolios is high with relatively few equities, insurers are exposed to higher quality investment grade bonds being downgraded to sub-investment grade or ‘junk’ status. In addition, insurers hold loans secured on commercial property, so we have placed particular emphasis on understanding exposures to malls, offices and hotels, which are seeing lower demand. The lower level of demand could stretch well beyond 2021.
The reassuring news, in terms of the impact on investment portfolios, is that insurance companies can withstand a sizeable level of downgrades in their investment portfolios given their level of capitalization pre-COVID-19. In addition, the relatively worst hit sectors of the economy (airlines, hotels, restaurants, etc.) are not sectors that insurers are particularly exposed to. Commercial property portfolios at the PRT providers are typically not more than about 20% of total general account assets. Within these mortgage loan portfolios, insurers had generally been de-risking away from some riskier areas, such as retail, prior to 2020.
A chart above shows our estimated impact on risk-based capital (RBC) ratios at a number of insurers, in a recessionary scenario. The RBC ratio coverage is the amount of excess capital insurers hold versus a minimum level, set by regulators with regards to the size of the company and the risks being run. A higher number indicates greater financial strength all else being equal, and the PRT industry average was about 400% prior to COVID-19.
This scenario analysis indicates that, although there is expected to be a negative impact on insurers’ capital coverage levels, insurers will remain well above minimum solvency levels in the scenario tested. Insurers with riskier asset portfolios going into 2020 will be more negatively impacted. It is also possible individual insurers have idiosyncratic exposure to harder-hit assets, resulting in a worse outcome than shown, and it is also possible insurers will take action to strengthen balance sheets to maintain their attractiveness to potential customers in this environment.
Low Interest Rates
Following the onset COVID-19, the Federal Reserve cut interest rates to near zero and long dated interest rates also fell significantly. We do not expect interest rates to rise significantly over the next few years.
A persistently low interest rate environment is negative for life insurance companies. Although the PRT providers hedge interest rates much more tightly than a typical pension plan, falling interest rates generally do increase reserve requirements and weaken capital levels, particularly where insurers offer products with minimum investment return. Lower absolute levels of rates also reduce the profit margins on many products insurers sell.
We regard the low interest rate environment as less of a solvency concern for the PRT providers, and more of head wind for future profitability going forward — which is more of an issue for equity investors. Indeed, the share price of stock listed insurance companies have underperformed the wider stock market in recent years, partially due to the falls in interest rates we have seen. The insurer share prices fell by more than 50% in many cases in March 2020, but have since recovered most of that back, as you can see from the stock price chart in the slideshow area above.
What Action Should Plan Sponsors Take?
Sponsors undertaking an annuity transaction can take heart in that all insurers active in the PRT market, at the time of writing, are still very likely to remain solvent and meet their obligations to make payments. The security of participant benefits is still likely to remain higher in an insurance company, with associated guarantees, than it is in any pension plan.
In a recessionary environment it is critical that plan fiduciaries are aware of the risks and undertake due diligence on insurance companies. Fiduciaries are encouraged by U.S. Department of Labor Bulletin 95-1 to select the “safest annuity available” and to “conduct an objective, thorough, and analytical search.” They are encouraged to hire an “Independent Expert” if they are unable to do this themselves. In the cases we have been involved with, special attention has been given to how a particular insurer has adjusted to the various effects of COVID-19.
Insurance companies report results periodically, with some mutual companies only releasing detailed data annually. Therefore, to be comfortable with an insurer at the point of an annuity placement, it is essential for your annuity placement provider or independent expert to have a deep understanding of how the insurers are likely to be affected in the current environment. Going beyond standard credit due diligence, for example, assessing insurers’ ability to service participants off site in a disaster environment, also takes on particular importance in these times.
Given the current market environment, plan sponsors need to have an annuity placement specialist that can form an opinion on the credit worthiness of participating insurers and provide fiduciary cover under DOL 95-1.
Because insurer solvency concerns are in a state of flux, the right specialist will have a rigorous process for looking at how the markets are affecting the insurers and their ability to provide the safest available annuity.
For our annuity placement clients, we have included additional documentation related to the current COVID-19 situation to give plan fiduciaries piece of mind in making their selection of an annuity provider.
James Walton, FSA, is an investment director in River and Mercantile’s Boston office. One of Walton’s duties is leading the due diligence of annuity providers.