by P.E. Kelley, Managing EditorLIFE&Health Advisor and L&HA e-newsLink.
e-mail at [email protected]
Jeff Katz is Head of Marketing Actuaries for Swiss Re. On the heels of Swiss Re’s recent sigma study: ‘Facing the Interest Rate Challenge,’ released last week, which explores the effects of three decades worth of downward interest rate trends on insurers, Katz sat down with me to discuss the implications of these trends for advisors and their clients.
PK: How has the low interest environment impacted the development of both protection products (life ins) and investment products (annuity) with respect to inherent guarantees behind these products?
JK: The low interest rate environment has affected all life and health products with durations beyond very short terms (e.g., group life insurance). Investment income is a meaningful component in pure protection products such as term life insurance, disability income insurance, and long-term care insurance. All else being equal, insurers pricing products using lower interest rates will have to charge more for the coverage. It is possible that a given insurer might elect to continue current rates rather than reprice or develop a new product to avoid this issue. Such an approach could work to meet sales goals in the short term, especially if rates rise relatively soon, but in the long run this will result in lower profitability than expected.
The same is true for life insurance protection products that involve a savings element, such as Whole Life (WL) and Universal Life (UL). While the impact of low interest rates may be mitigated by the use of long-term portfolio interest rates, over time portfolio rates will come down if new-money rates remain low. One obvious step is to reduce the guaranteed minimum interest rate used in calculating cash values (WL) or account values (UL). Most insurers have taken this step. As rates stay low, this will affect the excess interest credit component of policyholder dividends (WL) or account values (UL).
Products that emphasize the investment element are also challenged by low interest rates. Investment spread is typically the lone source of expense coverage and profits. Expected spreads of 100-200 basis points are not uncommon, and may be difficult to earn today on a risk-adjusted basis. In addition to lowering the minimum guaranteed crediting rates for deferred annuities and single-premium universal life, insurers might place limits on the amount of such business they wish to write over a given time period. This could be in the form of explicit limits, or could be implemented through other means. One example might be changing the producer compensation associated with certain products or certain levels of production. Another approach is to stretch for yield by sacrificing on some other element of an asset: longer maturities, lower credit quality, less liquidity. Each of these introduces new challenges, and may not work out as expected.
PK: What is the short term impact on insurer profitability, particularly in the wake of recent insurer exodus from traditional life/annuity books of business?
JK: The short term impact on insurer profitability is a mixed bag, and will depend on the individual circumstances of each insurer. The reserves for life products, including all of the products I mention in my answer #1 above, are traditionally invested in fixed income securities with relatively long durations, as the liabilities to be matched by these assets are relatively long. As interest rates declined, these bond portfolios tended to increase in value. An insurer could recognize short-term GAAP profits by selling appreciated bonds. Eventually, this action will produce losses to the extent the proceeds cannot be reinvested at high enough yields to support the interest credits built into the products’ pricing assumptions. (Statutory accounting requires spreading of such profit recognition over the length of the underlying liabilities through the Interest Maintenance Reserve mechanism.) A further potential offset is any change in DAC amortization due to investment yields falling short of expectations. The requirement to test recoverability could lead to acceleration of DAC amortization, lowering current profits.
Statutory profitability could be affected in the short term by asset adequacy testing, which uses current interest rates as a starting point and which requires assumptions about reinvestment and policyholder behavior. Any additional reserves required as a result of this testing will reduce statutory profits.
To the extent an insurer did an excellent job of asset/liability management, the drop in interest rates should not have a short term impact on profitability in either direction. Such an insurer’s assets are matched to their liabilities so that when it is time to pay claims or cash surrender values, sufficient funds will be available from asset cash flows (coupons and maturities).
Those insurers who have gotten out of traditional life or annuity businesses have done so more as part of a strategic and longer-term view than the short-term level of interest rates. There is certainly more pressure on asset intensive businesses in a low interest rate environment. But the decision to exit those products lines might have a negative short-term impact on profits to the extent the seller had to price the business low enough to attract a buyer. Any mismatches in asset/liability management would come home to roost all at one time through the sale of the business, rather than in smaller increments over a long period of time.
PK: What are the product design adjustments being made to shore up the viability of these products as we know them?
JK: Of the three questions, this is the one where I know the least. My sense is that low interest rates may be affecting the intricate designs of products known as universal life with secondary guarantees (ULSG), which rely on a complex set of “shadow account” calculations and other mechanisms to minimize the amount of reserves required to back the liabilities. But I do not know the specifics. A second trend is toward Indexed UL products (IUL). Such products take away a portion of the interest credits on account values to buy stock instruments (typically with the S&P 500 as the basis). This allows the insurer to offer excess interest credits if the stock market rises, while not penalizing policyholders if the market declines. Policyholders do not get the full amount of stock market appreciation, and they sacrifice some of the interest credit they receive in down markets. These products are not new, and I sense no addition of tremendously innovative new features, but their share of the market has increased. The policyholder participates in market appreciation without taking the full investment risk associated with variable life insurance (VL or VUL). Finally, the US has a position called the Illustration Actuary, who must sign off on the assumptions underlying policy value illustrations used by producers to sell permanent life products. Low interest rates may force those illustrations to present lower policy values, making sales more difficult. I am not sure of other ways these requirements might affect product design decisions, but I would not be surprised if this were one outcome of lower interest rates.