De-Risking as a strategy against earnings-volatilityIn a special report from A.M. Best, spread-compression and declining investment yields appear to be worsening due to COVID-19. Access the full report here.
OLDWICK, N.J., August 4, 2020—An AM Best analysis of U.S. life/annuity companies’ investment strategies amid the past decade of low interest rates found that the number of companies considered non-interest-sensitive more than doubled those deemed interest-sensitive.
However, those companies exposed significantly to interest rates have managed an average 76% of the industry’s invested assets in the last 10 years, and have different investment risk tolerances and strategies to aid in backing a product profile that is linked more to interest rates.
The low interest rates continue to hamper the life/annuity (L/A) industry, and with the COVID-19 pandemic impact, the trend is likely to exacerbate. In a new Best’s Special Report, “Interest Rates: Different Impact Severity, Different Strategies,” AM Best notes that insurers have been strategically de-risking their product portfolios for some time to counter the impacts on spread compression and earnings volatility.
Strategies have included exiting, re-pricing or de-emphasizing certain business lines, particularly those that are interest-sensitive. According to the report, companies considered interest-sensitive were those with a liability and premium mix concentrated in individual and group annuities, deposit-type contracts and interest-sensitive life products, as defined by the NAIC for statutory statement reporting.
The Bulk Of The Industry’s Earnings
Interest-sensitive companies typically generate the bulk of the industry’s earnings. Based on 2019 capital and surplus levels, interest-sensitive companies have nearly four times the amount of capital on average—approximately $2.3 billion, compared with roughly $610 million for non-interest-sensitive companies.
Commercial mortgage loans remain a staple of life insurers’ investment holdings, growing more than 80% to $578.5 billion in 2019 from $317.1 billion in 2010. Interest-sensitive companies were responsible for the growth, as their average exposure rose to 8.2% in 2019 from a low of 5.8% in 2010, versus a slight decline in non-interest-sensitive companies, whose average exposure came to 4.2% of invested assets in 2019.
Pre-tax net operating gains have been relatively consistent for non-interest-sensitive companies. In contrast, interest-sensitive companies have reported much more fluctuation over the last 10 years, although earnings have been consistently positive. Interest-sensitive companies also earn higher yields on average than non-interest-sensitive companies.
The low interest rates will remain a key obstacle as L/A insurers continue to invest new money, as well as the proceeds from higher-yielding maturing assets, into new assets at lower rates. The COVID-19-fueled economic slowdown has amplified the likelihood of dampened earnings in 2020 for spread and fee-driven businesses. AM Best believes there is the potential for further swings in the equity markets, and will be looking closely at companies’ asset-liability management programs as closely matched assets and liabilities can immunize against interest-rate sensitivities.
Excerpts from the Special Report
Product Profiles Matter
Spread compression and declining investment yields have been a concern for some time, and the current market volatility and uncertainty suggest the problem will only get worse, as crediting rates on many older blocks of business have been higher than available rates.
Still, interest-sensitive companies do earn higher yields on average than non-interest-sensitive companies. Yields on average declined for both types of companies over the last ten years. The average net yield for interest-sensitive companies declined a full percentage point from 2010 to 2019.
Non-interest sensitive companies saw a decline of about a half a point and have seen a modest uptick in portfolio yields the last two years, reflecting a strategic shift to extend duration in their bond portfolios and adding to their commercial mortgage loan allocation in order to garner additional yield.
Insurers are also cutting back or discontinuing sales of universal life products with secondary guarantees, divesting in-force legacy annuity blocks, and curbing sales of new variable annuities (VA) with living benefits and fixed deferred annuities in favor of indexed-based products such as indexed universal life and fixed indexed annuities, with the latter having lower GMIRs, typically less than 1%.
Registered index-linked variable annuities (RILAs), sales of which have grown significantly of late, have been the primary growth driver in the variable annuity product segment. Unlike regular variable annuities, RILAs share the downside risk with the policyholder. In addition, these products have generally been sold without any secondary guarantees, although a small number of carriers have recently begun offering these features.
Changes in Asset Composition
Insurers have also modified investment allocations and strategies on the asset side to maintain yields and limit further spread compression. Investment allocations between interest-sensitive and non-interest-sensitive companies already differed based on product profiles and asset matching, which has been exacerbated by the prolonged low interest rate environment.
One of the more important improvements made the last decade was in ALM. In 2020, the majority of the industry appears to be prudently focused on ALM, primarily through duration matching, and to a lesser extent cash flow matching. However, companies with longer-tail liabilities are still struggling to find long-dated assets. Also, the higher growth in less-liquid assets poses a potential issue if liabilities matched with these holdings need to be funded quickly.
To access the full copy of this special report, please visit www.ambest.com.
AM Best is a global credit rating agency, news publisher and data analytics provider specializing in the insurance industry. Headquartered in the United States, the company does business in over 100 countries with regional offices in New York, London, Amsterdam, Dubai, Hong Kong, Singapore and Mexico City. For more information, visit www.ambest.com.