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Edward Toy. (Photo: Risk & Regulatory Consulting)

Life Health > Annuities > Fixed Annuities

Cash Flow Gaps Could Catch Life Insurers Off Guard: Financial Examiner

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What You Need to Know

  • Edward Toy is a former portfolio manager who set up the NAIC Capital Markets Bureau.
  • He worries that insurers' investment risk modeling efforts focus on past problems and don't anticipate future issues.
  • He wants companies to think harder about the cash coming in and going out.

Some life insurers may not understand what rising interest rates and increased market volatility will do to their investment cash flow, an insurance investment expert said last week.

Edward Toy, an insurance company financial examiner, said those life insurers have focused mainly on long-term asset adequacy without thinking enough about how much money might be going into their investment portfolios — and coming out — in the near term.

“One of the lessons I have learned over many years is that, the more you focus on dealing with yesterday’s problem, the more you are not focusing on what the next problem is,” Toy said, in Washington, during a general session at the annual meeting of the American Academy of Actuaries.

Toy suggested that a new problem could be that some life insurers might have coped with low interest rates by agreeing to lock up assets for longer than before in exchange for higher rates of return, without knowing what the flow of cash produced by those less-liquid assets would look like during a period of rapidly rising interest rates and high market volatility.

What It Means

Rising interest rates should help bond yields, investment returns and long-term performance at the life insurers backing your clients’ life insurance and annuity benefits guarantees, according to most insurance industry observers.

But, if Toy is correct, some life insurers could go through challenging times before higher rates make their asset managers’ jobs easier.

Edward Toy

The American Academy of Actuaries is a group that represents actuaries, or people who have shown that they know and can apply the math needed to analyze insurance, pensions and other topics that involve elements of risk or uncertainty.

Toy appeared during an annual meeting session on the effects of the emergency of private equity owners on life insurers.

Toy has a bachelor’s degree from Dartmouth and a master’s degree in business from Wharton. He started out as a money manager at TIAA, and he later was director of trading and a portfolio manager at Artesian Capital Management.

In 2009, he began helping the National Association of Insurance Commissioners respond to the 2007-2009 Great Recession by setting up its Capital Markets Bureau.

In 2018, he began working for Risk & Regulatory Consulting in Stamford, Connecticut, as an insurance specialist.

He helps insurance regulators conduct financial examinations of insurance companies and handle other matters that require knowledge of insurance company investments.

“There’s just one company, of all the ones that I’ve done an exam on that, that said, ‘We’re taking a lot of investment risk, and we have a lot of systems in place to address that investment risk, and we are constantly, constantly updating our monitoring systems, because everything is always changing,’” Toy reported. “Everybody else that I’ve done an exam on, to varying degrees, said, ‘Oh, no, we understand what we’re doing; don’t worry.”

Many companies talk about their sophisticated investment risk modeling efforts. Insurer confidence in the completeness of risk models frightens Toy.

“Once you get comfortable with your model, you’re going to realize that there are two or three variables that you’re missing in that model,” Toy said. “Because the model dealt with last year’s problem, and what you’re trying to figure out is next year’s problem.”

The Last 30 Years

Toy said next year’s problems could be different partly because the world is different, and because life insurance companies run their operations differently.

Toy began working for TIAA in 1983, when defined benefit pension plans were still common in the United States and the 401(k) plan program was just five years old.

He was there before the 1987 Black Monday stock crash; the 2001 burst of the Dot-Com Bubble; the Great Recession; and the turmoil that occurred in March 2020 as lockdown rules related to the COVID-19 pandemic clamped down over the United States and much of the rest of the world.

“When I started in this business — way too many years ago — the typical life insurance company portfolio was 30% investment-grade utility bonds,” Toy recalled. “That world simply does not exist anymore.”

Whether a life insurer is owned by private equity investors, public shareholders or other types of owners, it might now be using capital from reinsurers to finance its business, and it might have hired outside investment managers.

The outside investment managers have an incentive to generate extra fees and justify their fees by increasing investment returns, by moving the life insurer away from what might have been overly conservative investment practices, Toy said.

He noted that life insurers might have coped with low interest rates and the need for higher returns by allocating more assets to investments that lock in cash for a long time or that have guaranteed returns but variable payment streams, such as construction loans, private equity funds and structured notes.

Potential Sources of Cash-Flow Problems

In some cases, Toy said, life insurers might have kept their exposure to credit default risk about the same but increased their risk of running low on cash.

“What I worry the most about is market value volatility,” he said. “These things where the fair market value at any given point in time, depending on what’s going on in the marketplace and the economic environment, could be all over the place.”

Here are five areas that Toy views as being potential causes of unexpected cash-flow challenges.

1. Rising rates might change how an ordinary investment works.

Toy noted that mortgage-backed securities might produce less cash when rates rise because borrowers will be less likely to make the payments needed to refinance their loans.

A key cash-flow measure for a typical mortgage pool — the conditional prepayment rate — has dropped close to 0%, from 6% or more a few years ago.

When an insurance company invests in a pool of mortgage loans, federal agencies typically back the loans. The insurance company will get the promised principal and interest payments, but it might not get the expected spurts of prepayment cash at the expected time.

Insurers typically track mortgage pools using “amortization schedules,” or theoretical tables showing when the money should come in.

“But that’s not cash flows,” Toy said. “You are expecting $10 billion to come in or $10 million to come in next year, and it’s not coming in. It’s going to be a tenth of that. What do you do from a cash-flow modeling standpoint?”

2. A life insurer might have to sell an asset early to raise cash.

Life insurers sell life insurance policies, annuities and other products with liabilities that stay in place for decades.

Life insurers emphasize that they buy long-term bonds and intend to hold the bonds until the bonds mature, rather than actively trading second-hand bonds on the “secondary market.”

When interest rates rise, the resale price of a low-interest-rate bond on the secondary market falls. The new price of the resold bond must be low enough that the expected yield will be about the same as the yield on the otherwise comparable, newly issued, higher-interest-rate bonds.

Even if the issuer is almost sure to pay all of the principal and interest, and the life insurer can carry the bond on its books at the original value, the insurer might lose 30% of the value if it actually has to sell the bond to get cash, Toy said.

3. Volatility could slash the market value of good assets.

Some life insurers have tried to increase returns by investing in emerging market bonds, or other attractive assets that were somewhere near the border between plain vanilla assets and more exotic assets.

In normal times, Toy said, those assets might be about as easy to sell as investment-grade corporate bonds, but, when a severe market disruption hits, it hits those slightly less conservative assets hard.

“You don’t just gradually sell,” he said. “You dump.”

4. Insurers might need to come up with cash to keep some assets in place.

Clients who try to keep universal life insurance policies in place may have to pay premiums, and they may have to pay more premiums than they expect when policy returns fall or cost-of-insurance costs increase.

Similarly, when a life insurer invests in construction loans or a bond fund, it might have to stick with commitments to feed in cash over time, rather than simply put cash in once.

If a life insurance company agrees to a five-year private-equity fund investment period, “a company has to be able to manage that because, when a capital call comes, there are 10 days to satisfy that capital call,” Toy said.

5. Insurers might have trouble pulling assets out of arrangements that produce less cash than expected.

Toy cited private equity funds as examples of arrangements that could lock life insurers into investments that are producing less cash flow this year than they produced last year.

“It’s not like they can sell the private equity fund,” Toy said. “They have to wait for that fund to liquidate their assets to be able to make distributions. So, those funds are not generating the cash flows they used to, and who knows when that will come back.”

In Other Meeting News

Ken Kent took over from Maryellen Coggins as the president of the American Academy of Actuaries.

Kent said he hopes to help college students who like math understand that becoming an actuary is a way to make a measurable impact on the world.

“I go back to the dream that, someday when I mention I’m an actuary to a group of people that I just met, it ignites conversation that is more than just, ‘Oh, you’re the people that can tell me how long I’m going to live,’” Kent said.

He cited retirement risk and new types of investment products as examples of areas of uncertainty that can benefit from academy members’ expertise.

Edward Toy. (Photo: Risk & Regulatory Consulting)


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