Life Insurance Industry: Stagnant Interest Or Future Prospects?

Interest rates have been in secular decline since the 1980s, with rates at historic lows from the 2008 financial crisis until late 2021. This low-interest environment has negatively impacted the financial performance of life insurance firms, as their assets and liabilities are heavily exposed to interest rate movements.

Life insurers hold large balance sheets, with a significant proportion of their assets in interest-earning bonds. When interest rates are low, investment earnings on these bonds decline, and insurers may shift funds to riskier but higher-earning assets. Additionally, the earnings on some life insurance products, such as annuities and cash-value life insurance policies, are dependent on the spread between what insurers earn in interest and what they credit to the customer. When market interest rates are low, this spread is compressed, resulting in lower earnings for insurers.

While interest rates began rising rapidly in late 2021, this does not automatically alleviate the challenges faced by life insurers during the extended period of low interest rates. As such, it remains to be seen whether the life insurance industry is still facing low interest rates and, if so, what steps companies are taking to adapt to this environment.

The impact of low interest rates on life insurance companies' financial revenues

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

• Life insurers keep large balance sheets, and a substantial share of their assets (over 60% in aggregate) are interest-earning bonds. When interest rates are low, investment earnings on these bonds decline.
• To raise investment earnings, some life insurers shifted funds out of investment-grade bonds and into inherently riskier but generally 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, depend on the spread between what life insurers earn in interest and what they credit to the customer. When market interest rates are low, the spread is compressed, and therefore so are earnings.
• Low interest rates can also affect life insurers' liquidity. Liquidity management is critical for life insurers, who strive to match asset cash flows with cash outflows to avoid asset-liability mismatch and interest rate risk. During periods of rising interest rates, cash flows from assets and liabilities can become badly mismatched, exposing insurers to losses from pressured asset sales to meet current obligations to policyholders.
• Finally, insurance companies seeking to issue bonds or roll over existing short-term debt may face substantially higher borrowing costs, putting downward pressure on profitability.

Looking forward:

• A gradual rise in interest rates would be positive for life insurance companies, as they would invest new cash at higher rates, beginning to reverse the steady decline in portfolio yields.
• A rapid rise in interest rates, however, would increase the risk of disintermediation, as customers surrender policies yielding lower rates and move funds into higher-yielding products.
• In the event of negative interest rates, U.S. life insurers would likely continue to invest in less liquid assets and structured securities in search of yield, or foreign currency-denominated bonds. However, if negative rates persist for multiple years, this could severely hamper growth opportunities and weaken capital adequacy.

The effect of low interest rates on the value proposition of life insurers in savings products

The life insurance industry has been affected by declining interest rates since the 1980s, with rates reaching historic lows in the aftermath of the 2008 financial crisis and the COVID-19 pandemic. This low-interest-rate environment has had a significant negative impact on the financial performance of life insurance firms.

Impact on Financial Revenues and Capital Requirements

Life insurers' financial revenues decline across products, and the capital requirements of guarantees increase. This is particularly true for life insurers with large guaranteed savings books, as their business has been shaped by a three-decade bull market for bonds. As a result, the value proposition of life insurers in savings products is increasingly questioned.

Impact on Investment Earnings

Life insurers hold a substantial share of their assets (over 60% in aggregate) in interest-earning bonds. With lower interest rates, investment earnings on these bonds decline. To mitigate this, some life insurers have shifted funds from investment-grade bonds to riskier but potentially higher-earning assets, such as asset-backed securities, collateralized loan obligations, derivatives, and real estate.

Impact on Earnings from Insurance Products

The earnings on some life insurance products, such as annuities and cash value life insurance policies, depend on the spread between what life insurers earn in interest and what they credit to the customer. Many of these products have a guaranteed rate of return for the consumer, which means that when market interest rates are low, the spread is compressed, and earnings decline.

Impact on Credit Spread

As a low-interest-rate environment persists, insurers can lower the terms of new policies, such as by reducing guaranteed rates. This progressively lowers future payouts and mitigates the compression of the credit spread. However, this can also lead to increased policy lapses as customers withdraw annuities or retire cash-value life insurance policies in search of higher yields.

Impact on Liquidity

Rising interest rates can affect life insurers' liquidity, particularly if there is a significant volume of policy lapses and annuity withdrawals. Life insurers strive to match asset cash flows with cash outflows to avoid asset-liability mismatch and interest rate risk. During periods of rising interest rates, cash flows from assets and liabilities can become badly mismatched, exposing insurers to potential losses from pressured asset sales to meet current obligations to policyholders.

In summary, the low-interest-rate environment has had a multifaceted impact on the value proposition of life insurers in savings products, affecting their financial revenues, capital requirements, investment earnings, and earnings from insurance products. As interest rates remain low or rise gradually, life insurers will need to adapt their strategies and product offerings to maintain profitability and meet customer demands.

How low interest rates affect the capital requirements of guarantees

Low interest rates have a significant impact on the life insurance industry. The interest rate environment affects the financial performance of life insurance firms, and life insurers are particularly vulnerable because their assets and liabilities are heavily exposed to interest rate movements.

Life insurers maintain large balance sheets, with a substantial portion of their assets (over 60% in aggregate) being interest-earning bonds. When interest rates are low, investment earnings on bonds decrease. As a result, some life insurers have shifted their funds from investment-grade bonds to inherently riskier but generally higher-earning assets, such as asset-backed securities, collateralized loan obligations, derivatives, and real estate.

The capital requirements of guarantees are also affected by low-interest rates. When interest rates are low, the earnings on some life insurance products, such as annuities and cash-value life insurance policies, are compressed. These products depend on the spread between what life insurers earn in interest and what they credit in interest to the customer. Many of these products have a guaranteed rate of return for the consumer, which means that when market interest rates are low, the spread between the interest earned by the insurer and the interest credited to the consumer is reduced, resulting in lower earnings for the insurer.

Additionally, low-interest rates can lead to an increase in policy lapses as customers withdraw annuities or retire cash-value life insurance policies in search of higher yields elsewhere. This further reduces the earnings of life insurers.

To mitigate the effects of low-interest rates, life insurers may need to adjust their strategic agendas. This can include pulling tactical levers, such as applying additional criteria to regulate the underwriting of new guaranteed products, reviewing pricing policies, and better aligning distributor remunerations with the economy of the products. Life insurers may also need to evolve their product range to better address customer needs, reshape customer journeys to provide high-quality advice and experiences, and take structural action to radically reshape their in-force business.

The challenges of new regulations for life insurance companies

Life insurance companies are facing a challenging environment due to persistently low interest rates, which has put pressure on their financial performance and valuations. As they navigate this difficult context, life insurers must also adapt to new regulations, such as IFRS 17, which will bring about further challenges. Here are some of the key challenges that life insurance companies will need to address in the context of the new regulatory landscape:

• Impact on financial revenues and capital requirements: Low interest rates will lead to a decline in financial revenues across products, and the capital requirements of guarantees will increase significantly. This will particularly affect life insurers with large guaranteed savings books, disrupting their business landscape.
• Questioning of value proposition: The low-interest-rate environment will prompt a re-evaluation of the value proposition of life insurers in savings products. Customers may increasingly seek capital protection, and life insurers will need to balance this demand with the demanding framework set by regulations like the Insurance Distribution Directive (IDD) and the Markets in Financial Instruments Directive (MiFID).
• Adapting product offerings: Life insurance companies will need to evolve their product range to better meet customer needs in the low-interest-rate environment. This may involve offering a broader range of savings solutions that address specific time horizons, risk appetites, liquidity profiles, and investment objectives.
• Enhancing customer journeys: The shift towards a more diverse range of value propositions will require a careful rethinking of sales and advisory processes. Life insurers will need to embrace digital technologies, such as remote and video-based advice platforms, and leverage automation tools to enhance the overall customer journey.
• Structural adjustments: Some life insurers may need to make radical structural changes to their business models to survive in the new environment. This could include transferring traditional life portfolios to other insurers or reinsurers or exploring closed-book runoff deals.
• Navigating regulatory adjustments: The tax and regulatory context is evolving in several markets, presenting both challenges and opportunities for life insurers. Companies will need to stay abreast of these changes and make strategic adjustments to remain competitive.
• Managing liquidity and credit risks: With the rise in interest rates, life insurance companies will need to effectively manage liquidity and address credit risks. They will need to navigate the risks associated with derivatives-related margin calls and policy surrenders, ensuring sufficient buffers to cushion potential increases in liquidity needs.
• Addressing interest rate hedging: Interest rate hedging programs will become crucial for life insurers to protect earnings and capital in a volatile interest rate environment. Different companies and products will employ varying hedging strategies, and effective management of these programs will be vital.
• Diversification and M&A strategies: Diversification into complementary insurance lines or non-insurance businesses can help life insurers mitigate the impact of low interest rates. Additionally, some companies may seek to acquire interest-sensitive businesses or divest from long-duration-asset-intensive operations.
• Adapting to tax code changes: Changes to the federal tax code, such as amendments to Section 7702, will impact certain life insurance products. Life insurers will need to adjust their offerings to comply with the updated regulations while still providing customer value.

Overall, life insurance companies face significant challenges due to the persistent low-interest-rate environment and evolving regulations. To ensure long-term success, they must adapt their strategic agendas, product offerings, and operational processes while effectively managing risks and capital.

Strategies for life insurers to adapt to the new normal of low interest rates

Pulling tactical levers to bring short-term relief

Life insurers should consider several tactical options to address the most pressing issues caused by low interest rates. This includes applying additional criteria to regulate underwriting new guaranteed products, reviewing pricing policies, and better aligning distributor remunerations with the economy of the products. Insurers should also revisit investment possibilities and asset-allocation policies and consider an updated view of credit risk and liquidity premiums. Additionally, selectively protecting the balance sheet through reinsurance contracts, derivatives, and swaps can help mitigate the impact of low interest rates.

Evolving the product range to better address customer needs

Life insurers need to offer a broader range of savings solutions to meet specific customer needs, including investment products with capital-protection solutions, existing and new retirement savings vehicles, and alternatives to purely financial payoffs. Exploring new, non-traditional risk coverages, such as divorce or unemployment, can help develop unique value propositions targeting specific customer segments.

Reshaping customer journeys to ensure high-quality advice and experience

The shift towards a more diverse range of value propositions requires a careful rethinking of sales and advisory processes. This includes adopting hybrid digital sales formats and greater personalization. Remote and video-based advice platforms can be more productive than traditional face-to-face meetings, and chatbots and automation tools can enhance the overall hybrid online and offline customer journeys. Segmenting customer groups and specializing agents and sales representatives can further increase personalized offerings and improve advice.

Taking structural actions to reshape in-force business

Some life insurers may need to explore more radical measures, such as transferring traditional life portfolios to other life insurers or reinsurers or splitting segregated funds to better match maturity profiles and limit yield dilution. Pooling IT infrastructure and operations with other players or outsourcing certain business processes can also help achieve economies of scale and expertise.

Focus on unit-linked products

With savers expressing a strong appetite for capital protection, life insurance executives may be tempted to focus their efforts on unit-linked products. However, this strategy may not adequately meet customer demands and could result in distribution channels losing relevance.

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