Best’s Special Report

Abrupt Interest Rate Hikes Could Pose Challenges to Life Insurers

The yield curve continues to flatten

April 23, 2018 — OLDWICK, N.J.–(BUSINESS WIRE)–How the U.S. Federal Reserve (Fed) proceeds on interest rate hikes remains critical to the U.S. life/annuity (L/A) insurance industry. According to a new A.M. Best special report, a slow, smooth increase would allow insurers to adjust crediting rates on existing products, reshape portfolio durations and help maintain credit quality for an optimal return; however, a sharp rise in increase rates could pose challenges to both sides of the balance sheet.

The Best’s Special Report, “Abrupt Interest Rate Hikes Could Pose Challenges to Life Insurers,” states that with short-term interest rates rising as a result of the Fed’s recent rate hikes while longer-term yields have been slower to respond, the yield curve continues to flatten. The resulting disincentive to match durations creates the potential for asset-liability management (ALM) mismatches for insurers with more spread-based liability profiles.

In addition, allocations to bonds maturing in less than five years is at its lowest point in nearly two decades as insurers looking for yield have lengthened their bond portfolios. As bonds with longer durations are more sensitive to changes in interest rates, upside interest rate shocks could squeeze spreads, leading to a jump in market value losses on asset sales as lapses increase.

Policyholder exodus?

A rapid rise in rates also could tempt policyholders of spread-based products to switch to competing products

A rapid rise in rates also could tempt policyholders of spread-based products to switch to competing products that offer higher returns based on current rates, such as bank certificates of deposit. For those insurers with minimal surrender protection or unattractive living benefits, the resulting increase in surrenders could weaken their liquidity and financial profiles, as they may be forced to realize losses on their corresponding bond portfolios.

L/A insurers with well-established and effective ALM programs are best equipped to navigate a rapidly rising interest rate environment after a prolonged period of low rates. The use of sophisticated enterprise risk management techniques can enhance life insurers’ ability to monitor asset-liability positions through cash flow analysis, duration, convexity, earnings and capital at risk. Interest rate moves are difficult to predict, and disintermediation risk, increases in hedging costs and capital strain due to reversal of unrealized gains potentially could lead to rating concerns.

A.M. Best believes insurers will have to carefully navigate the environment over the next few years, regardless of the direction interest rates follow.

To access the full copy of this special report, please visit here.