August 20, 2015
August 20, 2015
When the Federal Reserve finally begins to hike interest rates, there will be a re-pricing of virtually all existing financial assets. The companies that sell life insurance will be impacted too, as will their customers. Buyers and sellers of so called “participating” policies in which policyholders participate in the profits of the insurer through the receipt of dividends can expect to be among those seeing the biggest impact. Will higher interest rates be a positive or a negative for these companies and, by extension, good or bad for any current life insurance policies you may own?
To answer this question, it helps to think about how life insurance companies operate. Insurance company profits (or losses) come from two very different sources: underwriting and investing. During years in which the insurance company collects more in premiums than it pays out in claims and expenses, it earns an underwriting profit. Of course, if claims and expenses turn out to be larger than premiums, then there is an underwriting loss. The insurance company is willing to assume the risk of such losses because of what is called the “float,” the temporal differential between when it receives premiums and when it may be required to pay out claims. During that “float” period the insurance company invests premium payments and, as is shown below, investment returns drive profitability.
A review of 2014 financial data for four of the largest life insurance companies operating in the US shows the following:
Data from 2014 Annual Reports from the respective insurance companies
Based on these results, it’s apparently quite challenging to be a successful life insurance underwriter. However, the significant contribution of each company’s investment operation is undeniable, far and away exceeding the contribution from underwriting.
In general, the longer the insurance company can invest premiums, the higher the returns it can earn. This is good news for policyholders as it aligns the life insurance company’s interests with their own: everyone involved would prefer that policyholders enjoy excellent longevity. Similarly, policyholders have good reason to prefer that the long-term relationship into which they have entered is with a reliably profitable insurance company. Indeed, when insurers earn high profits, they face competitive pressure to pay policyholders higher dividends. They may also have to offer lower premiums and more attractive policy terms to win new policyholders.
Like so many other industries, the insurance industry is cyclical in nature.
As the chart shows, the life insurance industry is currently at a low point in its profitability cycle, which is largely attributable to the continuing low interest rate environment. While it’s true that interest rate declines initially made the bonds owned by insurance companies rise in value, the subsequent persistence of low rates ensures that low reinvestment yields will continue to drag down investment returns.
Bond yields are highly predictive of the overall investment returns earned by insurance companies because insurance companies don’t invest in especially balanced portfolios. The chart below from the National Association of Insurance Commissioners (NAIC) shows the average insurance company held 68% of its investments in bonds at the end of 2013. Such a heavy reliance upon bonds makes insurance companies among the most predictably conservative investors in the world. The conservative composition of insurers’ investment portfolios is not a matter of preference; rather, it is due to the fact that state regulators require insurers to maintain ongoing solvency via the construction of very safe investment portfolios. Long-term individual investors typically own stocks, but that isn’t true in the insurance industry. The mandate for conservative investment portfolios derives from the states themselves having the responsibility to step in and manage the affairs for insolvent insurance companies.
During periods of low profitability, competition is driven down, resulting in lower dividend payments for existing policyholders and higher premiums for new policyholders. The opposite holds true during periods of high profitability. As interest rates begin to rise, life insurance company CFOs will anticipate earning higher yields on their bonds and seeing a welcome boost to investment income (albeit after an immediate price decline in current holdings).
Though it may take some time, eventually the marketplace will transform as it shifts to a point higher in the profitability cycle. Policyholders will benefit as insurers pass down higher dividends to existing insureds, and offer lower premiums on new policies as they fight to attract and retain premium dollars to be invested.
Chances are that if you purchased a life insurance policy prior to 2007, your premium and policy terms are more attractive than what is available in the marketplace today. As interest rates rise, policyholders owning “participating” life insurance can expect to benefit.
Learn more about our insurance analysis approach here.