Low-Rate Environments and Life Insurance

The basic profit mechanism of general account life insurance companies does not work in a low-interest-rate environment. This is because low-interest-rate environments cause spread compression between the return earned on general account assets and the guaranteed, fixed benefit payments supported by these assets.

Over the short term, spread compression is part of doing business for general account life insurance companies. However, the current prolonged low-rate environment presents a significant challenge for life insurance company asset/liability management teams.

As I will discuss in future posts, a continued low-rate environment, the misrating of investment-grade corporate bonds, foreign insurance companies chasing yield in the American markets without hedging the currency risk, and a potential drop in the value of the dollar pose a significant possibility of systemic risk to our markets.

Life Insurance Company Assets – General and Separate Accounts

To simplify an understanding of life insurance company assets, it helps to set aside regulatory capital requirements. Having done this, life insurance company assets essentially consist of policy premiums. Obviously, as an insurance company grows, this asset pool of premiums includes returns earned from investing policy premiums. After receipt, an insurance company invests policy premiums in either their general and/or separate accounts. General and Separate Accounts differ in the nature of the obligations for which the assets are being held and invested. 

General Accounts support contractual obligations for guaranteed, fixed benefit payments. This includes products like fixed annuities, whole life insurance policies, and GICs. Separate Accounts support liabilities associated with investment risk pass-through products. This means the owner of the product bears the investment risk. This includes products like variable annuities, variable life insurance, and certain novel pension products.

Therefore, as a result, General Accounts hold the majority of life insurance company assets. According to the most recent ACLI insurance statistics, General Account assets totaled $4.4 trillion. In comparison, Separate Account assets totaled $2.7 trillion in 2018.

State laws allow Separate Accounts to be invested in common stocks and other comparatively riskier assets, whereas various rules generally require General Account assets to be invested more conservatively.

Life Insurance Company General Account Bond Holdings

Bonds are publicly traded debt securities. As of 2018, bonds represented 48% of life insurance company assets. The total value of these bond holdings is approximately $3.5 trillion. Bond holdings in Separate Accounts were only $399 billion in 2018. By comparison, bond holdings in general accounts amounted to $3.1 trillion in 2018.

This means that bonds make up 70% or $3.1 trillion of the $4.4 trillion of life insurance company general account assets. This is a significant allocation and life insurers theoretically bear this investment risk themselves. However, taken to its furthest extent, this investment risk might actually be born by the beneficiaries and the Federal Government.

A variety of organizations, including domestic and foreign corporations, the U.S. Treasury, U.S. government agencies, and state, local, and foreign governments issue these bonds.

Long-term U.S. Treasuries totaled $151 billion, U.S. government obligations $52 billion, and foreign government bonds $95 billion. Bonds issued by U.S. states, territories, and political subdivisions equaled $49 billion. Bonds issued for revenue, assessment, and industrial development totaled $125 billion.

“Unaffiliated Securities” make up the majority ($2.1 trillion, or almost 70%) of life insurance company General Account bond assets. “Unaffiliated Securities” largely means U.S corporate debt, therefore, the majority of life insurance company General Accounts are invested in corporate bonds.

Life Insurance Company General Account Bond Portfolio Maturities

Bonds have limited lives and expire on a given date, called the issue’s maturity date. ACLI statistics show 30 percent of general account bonds have a maturity of between five and ten years. Another 25 percent matured between one and five years. 21 percent have a maturity over twenty years. 18 percent matured between ten and twenty years, and 7 percent have a maturity of one year or less.

Corporate bonds represent the largest component of life insurance company General Account assets at almost 70 percent. In fact, these investments have grown at a 1.9 percent annual rate in the last decade. Consequently, based on ACLI bond maturity statistics, life insurance company General Accounts have the largest portion of their assets invested in U.S. corporate debt with maturities of 10 years or less.

How Life Insurance Companies Make Money on Their General Account Policies

Warren Buffet generally explained the concept of how insurance companies make money in his 2002 Berkshire Hathaway Shareholder Letter. Mr. Buffet stated that: “[t]o begin with, float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss,” which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money.”

Life insurance companies execute the strategy described by Mr. Buffet, as follows: They derive their profits from the spread between their General Account earnings and what they credit as interest on insurance policies. For simplicity’s sake, Profit = general account return – guaranteed interest credited on policies.

What is a Prolonged Low-Rate Environment?

A low-interest rate environment occurs when the risk-free rates of interest set by central banks are lower than the historic averages for a prolonged period of time. In the United States, the risk-free rate is generally determined based on the interest earned on Treasury securities.

Most of the developed world has experienced a low-rate environment since 2009 as central banks cut interest rates to effectively 0% in order to stimulate economic growth and prevent deflation. This has been referred to as quantitative easing, or QE. The generic purpose of lowering interest rates is to stimulate economic growth by making it cheaper to borrow money to finance investment.

On December 19, 2018, the Fed raised interest rates for the fourth time in 2018 and the ninth since the Fed began raising rates from near-zero in 2015. The Fed raised the benchmark short-term interest rate to a range of 2.25% to 2.5%. However, the Federal Reserve cut interest rates 3 times in 2019. Reversing nearly all of 2018’s rate increases as “uncertainty from President Trump’s trade war and slowing global growth continue to pose risks to the United States economy.” The benchmark short-term interest rate has now fallen to 1.5% to 1.75%. Therefore, we are mired in a prolonged, 11-year low-interest-rate environment.

What is the Average General Account Policy Crediting Rate?

Over the past 75 years, the average return of an investment that approximates the high-quality corporate yield curve (investment grade corporate bonds) has been around 6 or 7 percent. Thus, the interest credited on guaranteed products issued by life insurance companies has been in line with this return minus costs, management fees, and a reasonable buffer (profit).

Why Does This Matter?

During times of persistent low-interest rates, returns from General Account portfolios predominated by US corporate bonds might be insufficient to meet guaranteed obligations to policyholders. Life insurance companies typically offer products with guarantees regarding the level of income over the life of the policy. The life of these policies could be 30 years or more. Life insurance companies could be facing a mismatch between assets and liabilities because they wrote a significant portion of these products when the economic outlook appeared dramatically different.

As stated, most life insurance contract liabilities are long-duration contracts. In a low-interest-rate environment, it is challenging for a life insurance company to find relatively low-risk, high-yielding, long-duration assets to match fixed annuities and other products that guarantee a minimum annual return.

Older fixed income insurance products have guarantees that closely match or likely surpass current investment portfolio yields. Consequently, this is likely to put a strain on life insurance companies due to spread compression or negative interest margins.

Over the short term, this economic reality (Loss) is the cost of doing business for a life insurance company. Over the long term, this presents a significant challenge for life insurance company asset/liability management teams and the possibility of systemic risk.

For More Information:

One comment

Leave a Reply

%d bloggers like this: