Life Insurance Industry: Low Interest Rates Forever?

Interest rates have been in a secular decline since the 1980s, hitting historic lows during the 2008 financial crisis and Great Recession. Prolonged periods of low interest rates negatively affect the financial performance of life insurance firms. Life insurance companies are some of the largest purchasers of bonds and mortgages in the United States, and low interest rates cause investment earnings on these bonds to decline. This has led some life insurers to shift funds to riskier but higher-earning assets. Low interest rates have also made insurance companies' products less attractive, resulting in lower sales and income from premiums. However, in late 2021, interest rates began rising rapidly, which may positively impact the financial performance of life insurers.

The impact of low interest rates on different insurance product structures

Interest rates and insurance are deeply interconnected, and interest rate risk is a significant factor in determining an insurance company's profitability. Low interest rates have a negative impact on all insurers, as fixed-income investments are a crucial source of revenue. The life insurance industry, in particular, is susceptible to interest rate fluctuations due to its focus on long-duration and savings-type products.

Life Insurance:

• Assets and Liabilities: Life insurers maintain large balance sheets, with a significant portion of their assets (over 60%) in interest-earning bonds. During periods of low interest rates, investment earnings on these bonds decline, prompting some life insurers to shift funds to riskier, higher-earning assets.
• Earnings Spread: Life insurance products like annuities and cash value policies rely on the spread between the company's interest earnings and the interest credited to customers. Low interest rates compress this spread, reducing earnings.
• Solvency: While low interest rates can create spread compression on earnings, they have not significantly impacted life insurers' solvency. Regulatory requirements, such as annual cash flow testing, help ensure that life insurers remain financially sound.

Non-Life Insurance:

• Profitability Gap: While low interest rates negatively impact all insurers, the profitability gap between the life and non-life sectors may widen. Non-life insurers may experience a greater impact on their investment earnings.
• Investment Strategies: Sustained low interest rates have encouraged insurers to invest in higher-risk, higher-yielding assets. However, stricter solvency frameworks have made certain asset classes more expensive, impacting portfolio yields.

To enhance profitability, insurers must focus on redesigned products, repricing, and capital optimisation strategies.

How low interest rates affect the risk and recovery options of insurance products

Interest rates have been in secular decline since the 1980s, but from the time of the 2008 financial crisis until very recently, interest rates were at historic lows. Prolonged periods of low interest rates negatively affect the financial performance of life insurance firms in multiple ways.

Risk

Life insurers keep large balance sheets, and a substantial share of their assets (over 60% in the aggregate) are interest-earning bonds. With lower interest rates, investment earnings on bonds decline. In an effort to increase investment earnings, some life insurers shifted funds out of investment-grade bonds into inherently riskier but generally higher-earning assets, such as asset-backed securities, collateralized loan obligations, derivatives, and real estate.

Additionally, lower interest rates can also negatively impact an insurance company's risk profile as an equity investment if analysts believe that the company may struggle to meet future financial obligations. Lower levels of equity investment typically mean lower levels of assets for insurers.

Recovery Options

As low interest rates persist, insurers can lower the terms of new policies (e.g. by lowering guaranteed rates), thereby progressively lowering future payouts and mitigating compression of the credit spread.

However, insurers cannot increase earnings by selling existing low-yield bonds and using the proceeds to purchase recently issued, higher-yielding bonds. The resulting capital losses from selling at heavily discounted prices would offset the benefits from purchasing higher-yielding bonds.

The effect of rising interest rates on insurance company profitability

Interest rates have a significant impact on the insurance industry, especially life insurance. After a prolonged period of low interest rates, rates began to rise in late 2021, which can have both positive and negative effects on insurance companies' profitability.

Positive Effects on Profitability

Higher interest rates can improve the financial performance of life insurers in several ways:

• Increased interest income: As existing bonds mature, they can be replaced with higher-yielding bonds, leading to higher interest income over time.
• Higher investment returns: Life insurers can benefit from greater returns on their investment portfolios, where premiums are invested. This can lead to higher investment gains passed on to policies.
• Improved portfolio earnings: The net spread of insurer portfolio earnings over guaranteed interest rates on annuities and some cash-value life insurance policies will increase, resulting in higher earnings margins.
• Attractiveness of new money products: Rising interest rates can make "new money" products, such as universal life and indexed universal life contracts, more attractive to both new and existing policyholders due to richer benefits and reduced costs.

Negative Effects on Profitability

However, there are also challenges that may offset some of the positive effects:

• Time lag: It may take a significant amount of time for higher interest rates to meaningfully impact life insurers' financial performance as many policies and retirement savings products are in force for many years.
• Capital losses on existing bonds: Insurers cannot easily sell their existing low-yield bonds to purchase higher-yielding ones without incurring substantial capital losses on the sale of the old bonds.
• Increased policy lapses: Some customers may withdraw annuities or surrender cash-value life insurance policies in pursuit of higher yields elsewhere, reducing the earnings gains from higher interest rates for insurers.
• Liquidity issues: Rising interest rates can affect life insurers' liquidity as cash flows from assets and liabilities may become mismatched, leading to potential losses from pressured asset sales to meet obligations.
• Higher borrowing costs: Insurance companies seeking to issue bonds or roll over existing short-term debt may face substantially higher borrowing costs, putting downward pressure on profitability.
• Impact on risk profile: Lower interest rates can negatively impact an insurance company's risk profile as an equity investment if analysts believe the company may struggle to meet future financial obligations.

While rising interest rates can have a positive effect on insurance company profitability, it is not an immediate fix to the challenges posed by a prolonged period of low interest rates. The positive effects may take time to materialize, and there are also negative consequences that can offset the benefits. Insurance companies need to carefully navigate this changing interest rate environment to maximize their profitability.

How low interest rates affect the investment strategies of insurance companies

Interest rates have been in secular decline since the 1980s, but from 2007 to 2009, interest rates were at historic lows due to the financial crisis and Great Recession. This decline in interest rates negatively affected the financial performance of life insurance firms.

Life insurance companies keep large balance sheets, and a large share of their assets (over 60%) are interest-earning bonds. When interest rates are low, investment earnings on bonds decline. In response to this, some life insurance companies shifted their funds from investment-grade bonds to riskier but higher-earning assets, such as asset-backed securities, collateralized loan obligations, derivatives, and real estate.

The earnings on some life insurance products, such as annuities and cash value life insurance policies, are dependent on the spread between what life insurance companies earn in interest and what they credit in interest to the customer. When market interest rates are low, the spread is compressed, and therefore so are earnings.

In addition, low interest rates can make insurance companies' products less attractive, resulting in lower sales and, thus, lower income in the form of premiums that the insurance company has available to invest.

However, insurance companies are constantly receiving premiums and therefore investing new money. Even though the market value of bonds already held decreases with rising rates, insurance companies can simply hold on to them and collect the payments. At the same time, when they purchase more bonds and other fixed-income investments, these new investments will yield more than the previous ones. This raises the average yield of their holdings and increases their interest income. Thus, rising rates tend to mean rising profits for insurers as they can add higher-yielding assets to their portfolios.

The impact of rising interest rates on insurance policyholders

Interest rates have been in a secular decline since the 1980s, but they began rising rapidly in late 2021. This shift presents challenges and opportunities for insurance companies and policyholders. Here are some key ways in which rising interest rates impact insurance policyholders:

Impact on Insurance Companies

Insurance companies, especially life insurers, are significantly affected by changes in interest rates. As major purchasers of bonds and mortgages, insurers are heavely exposed to interest rate movements. Higher interest rates generally improve the financial performance of life insurers as they can invest premiums in higher-yielding assets. However, this improvement may take time as insurers typically hold bonds to maturity.

Policy Dividends and Crediting Rates

Policyholders of whole life or universal life insurance can benefit from rising interest rates through increased dividend or crediting rates. As insurance companies generate greater returns from their investments, they can pass on these gains to policyholders. However, there is often a lag in this process as insurers' portfolios may contain long-term investments locked in at lower rates.

New Money Products

In a rising interest rate environment, insurance companies may shift towards "new money" products. These policies are backed by newer investment portfolios that can more easily take advantage of current interest rates. "New money" products may offer richer benefits and reduced costs, making them attractive to new and existing policyholders.

Impact on Liabilities

Rising interest rates can decrease an insurance company's liabilities by reducing future obligations to policyholders. However, lower interest rates can also make insurance products less appealing, leading to lower sales and premium income. The net impact on profitability depends on whether the decrease in liabilities outweighs any reduction in assets.

Liquidity and Borrowing Costs

Rising interest rates can affect an insurance company's liquidity, which refers to the ease of converting assets into cash. Insurers strive to match asset cash flows with cash outflows to avoid mismatches and interest rate risks. During periods of rising rates, cash flows from assets and liabilities can become misaligned, leading to potential losses from pressured asset sales to meet obligations. Additionally, insurance companies seeking to issue bonds or roll over short-term debt may face higher borrowing costs, impacting profitability.

Policy Lapses and Withdrawals

Higher interest rates may encourage some policyholders to withdraw from annuities or surrender cash-value life insurance policies in search of higher yields elsewhere. This trend could depress the earnings that life insurers would otherwise gain from increased interest rates.

In summary, rising interest rates have a complex impact on insurance policyholders. While they can lead to increased dividends and more attractive investment options, they may also result in changes to insurance company strategies, liquidity challenges, and increased policy lapses. Policyholders should regularly review their insurance policies and consider seeking expert advice to ensure their policies remain aligned with their financial goals.

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