What would happen to life insurers in this current interest rate environment?

[muscleman]

It seems to me that rates will be very unlikely to go up from here, and could go down again if any slow down is seen in the economy. How do life insurers do in this kind of environment? What about other financial companies like banks?

[no_free_lunch]

Viking talked about this in another thread.  What appears to be happening, is life insurers will push for higher premiums (and therefore lower combined ratios) to offset the weaker investment income.

[muscleman]

Viking talked about this in another thread.  What appears to be happening, is life insurers will push for higher premiums (and therefore lower combined ratios) to offset the weaker investment income.

 

Thank you! Do you recall the title of that thread? I'll try to find it.

[Viking]

Here is a snipet of what RBC had to say in their weekly report today. I have to say i am pretty happy with RBC and their coverage of the insurance industry; lots of good information that really helps to understand the complex issues at play.

 

“For obvious enough reasons the interest rate narrative showed up most strongly on life insurance results and conference calls... ...interest rates declined about 40 basis points in the quarter and more than 100 basis points from a year ago. ...The impact...showed up in two main forms – actuarial assumption review changes and impact on net investment income and/or related spreads.

 

The assumption change narrative is very straightforward, multiple companies lowered their long-term interest rate assumption, often to 3.75%.  ...In general these changes had minimal impact on GAAP results, manageable impacts on statutory reserves/capital and minimal ongoing implications for earnings. The more impactful part of the narrative was the impact on spread based businesses...investment income earned in the quarter was down.

 

The net result of all of this is that, as expected lower interest rates are already impacting earnings both in the 3Q and prospectively over however long one wants to assume rates will remain low. ... The impacts tend to be small, companies have suggested maybe 1-3% of earnings per year, but that does add up, particularly if ‘forever’ is your answer to how long longer is. The other part of the narrative is what companies are doing about it. Some have been pretty successful with hedging. Most have repriced products... For most companies its only 7-10% of their portfolio that gets exposed to reinvestment so this is a narrative that less resembles a freight train and more resembles a steam roller. It’s possible to outrun a steam roller, at least for awhile.

 

So our bottom line on interest rates is they are having an impact, the size of the impact is manageable but the duration of that impact is uncertain. That might be sufficient to make valuations across the life insurance sector look attractive, it’s probably not sufficient to provide them a catalyst to get better.”

 

 

[Cigarbutt]

Note to muscleman:

This post is not for you, it’s simply a slightly modified entry that I logged in one of my files this AM. If, by any chance, this is helpful, that’s fine also. Our paths crossed here some time ago (you were looking for places to park cash) and the discussion evolved to the outlook on interest rates. My reply to a question of yours included a reference to rocket science and heroin use and, understandably, was kind of left open-ended. Since then, I closed some relevant transactions last summer and still have some kind of interest in the matter. Continue reading at your own risks. :)

 

In the last 10 years, low interest rates have been a bummer for many financials and insurers in general, with low rates contributing to low NIMs (banks), low investment yields (P+C insurers) and low and declining net spreads (life insurers). So, low interest rates have pushed down return on capital measures, producing lowish returns and life insurers’ market caps have barely reached the pre-crisis levels, accounting for new capital minus dividends at a time when low interest rates have unequivocally pushed up (the gravity argument) valuation levels elsewhere underlining again that everything is relative. What happened to life insurers during the last financial crisis and since then has been incredibly fascinating. At this point, many life insurers’ equity value has ‘recovered’ but the price to book value has not, implying that there may be potential upside here (potential conclusion from the research mentioned by Viking above), a view I disagree with.

 

In a low interest rate world, P+C insurers at least can re-price yearly to catch up but life insurers are stuck with long term contracts that contain various levels of explicit and implicit guaranteed returns. If you look at the long term trend in those guaranteed returns, the trend is getting lower but there has been a significant lag as it takes a while for the new policies to have an impact on the bunch of policies in force.

 

So, if looking for a target in this field, you have to come up with the odds of rates lower for longer, consider the possibility of negative interest rates and even discount for the possibility of an associated corrosive effect from deleveraging (don’t do that on an empty stomach). Before elaborating future-looking scenarios, you may want to take a look at what happened to Japanese life insurers in the last 30 years and to wonder if we are turning Japanese. Summary: The story is fascinating and repeatable and is still ongoing. Japanese life insurers ‘adapted’, more or less. They gradually lowered the promised return on liabilities by using different mechanisms (liability and asset side). Most have, so far, survived and the country has opened its large market (second in the world after the great again country) to foreign capital but returns, overall, for the investors, have been incredibly disappointing and many, punctually especially around 1997-2001, have failed, a phenomenon rarely seen in the land of the rising sun. I won’t expand here but I think the failures during that period were related to excessive reaching for yield behavior associated with expectations that rates would soon rise, resulting in enduring negative net spreads, an issue very difficult to deal with for a life insurer. Somehow, Japanese life insurers came through the Great Financial Crisis and the big feature was investing in longer duration JGBs although the story has evolved recently, as the last chapters of this story are bring written, with a very unusual thirst for yield that includes unhedged bets on foreign and peripheral alternative assets. I have written a tentative epilogue on this.

 

So, if looking for a US target in this field, life insurers will continue to try to adapt and some seem to be better prepared and likely to do better, relatively speaking. I would look at individual names and assess:

---On the liability side

--the composition and diversity of the product mix

Ranked in order of decreasing interest risk, I would look at the fraction of: fixed annuities, universal life and guaranteed contracts, and then variable annuities, whole life and term life.

---On the asset side

--the composition of the portfolio (tedious work)

It seems that life insurers behaved reasonably well after the 2007-9 stun, slowly adjusting to the new normal but the net spread has been coming down, the duration mismatch strategy (going longer) has been hurt by the recent inversion and lower reversion and IMO excessive reaching for yield has reared its ugly head in some quarters. And the steam roller may gather steam in a lowering rate environment because of lower than expected investment income, negative impact on the net spread, potential regulatory requirements to fund reserves for the growing asset-liability mismatch and associated liquidity strains in many parts of the Market, including the bond market which hasn’t been really tested in such a long time with a supposedly omnipresent and omnipotent public partner.

---The soundness of the risk management and hedging tools

 

I think I’m done here and don’t intend to follow-up on additional questions, perhaps others will.

 

Final note:

I’ve been haunted by QE and, retrospectively looking, QE-boosted secularly lower interest rates saved the day for life insurers and allowed capital replenishment, time to digest the mark-to-market liquidity pain and allowed most of them to come out (mostly) unscathed but I continue to wonder if this was not a pyrrhic victory. When we last talked about the steepness of the curve, I alluded to the escape velocity concept used in rocket launches and then suggested that the Fed was hoping for the second reactor to fire. Since then, the Fed has seen that this could not happen (long rates went down) and has started to lower short term rates hoping that the second reactor does eventually fire but, even if the yield curve slope has been restored, contrary to last time, the hope is based in a context where the rocket is still vertical but is losing altitude. So these days, I’m looking for ways to benefit from this and I’m also shopping for parachutes. In fact, if bright, energetic and a true salesman, I would set up a hedge fund with seeded money earmarked for the eventual acquisition of surrendered policies at a discount, hopefully at the height of liquidity constraints. But I’m not. Today, I will cover up some trees and bushes as we are expecting an unusual amount of early snow and this could be a fun winter.

 

[muscleman]

Thank you Cigarbutt.