In the past few years, we have had no shortage of entries about the historic low-interest-rate environment and the beating that life insurance policies took because of it. Whole life dividends have dropped, current assumption universal life performance has been driven down, and in some cases, cost of insurance (COI) increases have raised carrying costs by over 200%. All primarily because of low-interest rates. We have even written about the effect of the low rates on long-term care insurance policies, though we do not deal with them. At times it has been downright depressing to report on well-known industry executives decrying the low rates were “destroying the viability of insurance companies” and leaving us in an “environment…unsustainable over any reasonable period.”
In the last year or so, we have seen a rise in interest rates with the 10-year Treasury recently crossing the 3% mark. It is only natural to think of a rise in rates as good news for the insurance industry. Carriers collect premium dollars, invest the monies in fixed instruments and then pay out the benefits in the future so rising rates would be a plus, right? Not so fast.
Two weeks ago (April 23, 2018), AM Best released a special report in which it cited continuing low rates, a flattening yield curve, regulations, potential for market corrections and the need for innovation as reasons for a “negative outlook” on the US life and annuity market (1).
One issue stood out – the potential for an abrupt increase in interest rates. As pointed out in the report, carriers “prefer gradual increases” in interest rates that “allow them to adjust their credited rates on liabilities and their asset portfolios to optimize returns.”
The report noted current underlying factors – increasing wage growth, the effect of the Tax Cuts and Jobs Act and tariffs on steel and aluminium – that “could cause a rapid increase in interest rates.”
Wages have grown at the fastest pace since 2009 (2). A recent Wall Street Journal article noted that firms are competing to “hire scarcer workers.” The same article reported inflation hit the Fed’s 2% target and that a “sustained pickup in inflation in the months ahead” driven by trade tariffs and a weak dollar could “push up prices” on imports (3).
The effect of the Tax Cuts and Jobs Act may not be the only reason the federal government debt is ballooning, but it is expanding at a fast pace and that may increase interest rates. The Treasury announced in an April 30th Press Release that during the January to March 2018 quarter, it had borrowed $488 billion, a record for that period (4). A Bloomberg report noted that spending increased at three times the pace of revenue growth in the October-to-March period (5).
A study that measured the influence of budget deficits on interest rates showed there is a “statistically and economically significant” relationship between deficits and long-term interest rates. It projected that when the deficit to GDP ratio increases by one percentage point, long-term interest rates increase by roughly 25 basis points (6).
According to a recent Congressional Budget Office (CBO) report, federal debt held by the public is projected to rise in a relatively straight-line fashion from 78 percent of GDP at the end of 2018 to 96 percent of GDP by 2028. That percentage would be the largest since 1946 and well more than twice the average over the past five decades (7).
If the study and projection are to be believed, we can expect long-term interest rates to increase by as much as 4.5% over the next decade. The increase may not lead to a harmful outcome for insurance carriers – if the increases are not dramatic, but slow and steady. A slow, smooth increase allows carriers to “adjust crediting rates on existing products, reshape their portfolio durations and help maintain credit quality for an optimal return that would satisfy their risk-based capital ratios and risk tolerances. (1)“
But a quick jump in rates could cause issues, as the AM Best report points out, including disintermediation with policy holders dropping life and annuity policies for higher returns elsewhere in instruments like bank CDs. Carriers with “minimal surrender protection” would be hardest hit. Policyholders left could take advantage of low-cost policy borrowing opportunities to increase loans on policies. Both events would cause liquidity risks for carriers. In the past when this has occurred, carriers had to liquidate investments prematurely to raise cash for surrender and loan payments.
According to the AM Best report, the search for higher yields has caused insurers to lengthen bond maturity with “portfolios at their longest durations in at least 17 years,” with those at the short end – maturing in less than five years – “at the lowest point in nearly two decades.”
The effect of interest rates on bond prices is somewhat dependent on bond duration. AM Best data shows the current market value of life industry bonds is about 6.3% over book value. However, according to the report, a 100 basis point change in interest rates would bring the market value below book value, creating unrealized losses and the unrealized gains that accrued while rates were at historic lows could quickly start to reverse, which would negatively affect reserves. The saving grace is the “longer-tail nature” of most insurance carrier liabilities, but again, liquidity needs would exacerbate the problem.
The life insurance market and insurance carriers, in general, have weathered an extremely fierce economic storm in the last decade. Let’s hope the next few years bring smooth sailing with gently increasing rates and a calm financial market.
- Best’s Special Report, Abrupt Interest Rate Hike Could Pose Challenges to Life Insurers, AM Best, April 23, 2018
- America Gets a Raise: Wage Growth Fastest Since 2009, CNN Money, February 2, 2018
- US Inflation Hit Federal Reserve’s 2% Target in March, Harriet Torry and Andrew Tangel, Wall Street Journal, April 30, 2018
- US Treasury Press Release, https://home.treasury.gov/news/press-releases/sm0375
- Mnuchin Sees Solid Treasuries Demand After Record U.S. Borrowing, Saleha Mohsin and Randy Woods, Bloomberg.com, April 30, 2018
- Budget Deficits and Interest Rates: What Is the Link?, Edward Nelson and Jason J. Buol, Federal Reserve Bank of St. Louis.
- Congress of the United States Congressional Budget Office, The Budget and Economic Outlook: 2018 to 2028