Much like a Christmas tree, the Fed’s December rate hike is not looking so fest-inducing in the wintry glare of January.
When the Federal Reserve Board raised benchmark interest rates for the first time in nearly a decade, many in the insurance industry expressed relief. After all, for at least seven years, companies have been struggling to eke some safe returns to offer rates that would attract business.
“Life insurance company executives are definitely cheering the Fed on. I can hear them yelling, ‘Yellen, Yellen, Yellen,’ ” Robert R. Johnson, president and CEO of the American College of Financial Services, told InsuranceNewsNet on the day the announcement was made.
The Federal Reserve raises its benchmark lending rate to make sure the economy doesn’t grow too fast, and the central bank lowers rates to make it less expensive to borrow in hopes of stimulating economic activity.
So, not only did the increase portend better bond returns for insurers, it was also an endorsement of an improving economy.
The Effect on Life Insurance Carriers
For life insurance carriers, rising rates ease spread compression.
Spreads compress, or tighten, when carriers, paying out liabilities to life insurance policyholders and annuitants at a fixed rate, find that they can only reinvest premiums at even lower rates because interest rates have declined.
Carriers find they can’t make enough on their invested assets to deliver on their contractual liabilities — a phenomenon that has dogged life carriers since rates began their long decline.
As rates rise, insurance carriers will be able to invest premiums and roll over maturing bonds into higher-yielding investments. About 74 percent of the life insurance industry’s invested assets are in bonds.
“Bond yields are going to rise in response to higher rates,” said Johnson, author of Invest with the Fed.
“This initial 25 basis point change isn’t really going to have an impact on the economy,” he added. “But what it does is it signals a future course of action to the Fed. The last thing the Fed wants to do is raise rates and reverse course in the near term.”
With the Fed having been so cautious before raising rates for so long, some analysts say it augurs well for more than one rate increase in 2016.
Market watchers have been talking about how fast rates should rise this year.
A slowly increasing rate environment is the ideal scenario for the life insurance industry as management reinvests assets in bonds with progressively higher yields.
Gradual rate increases allow carriers to adjust their credited interest and more appropriately match their assets with the liabilities, according to actuary Larry Bruning and researchers Shanique Hall and Dimitris Karapiperis.
Their research was published in 2015 by the Center for Insurance Policy and Research, the research arm of the National Association of Insurance Commissioners.
Moody’s Investors Service said it expects the federal funds rate to increase by 150-200 basis points over the next two years, half the pace of increases during the last tightening cycles in the mid-2000s.
“Life insurers will benefit from a gradual improvement of investment returns, particularly those companies that have written significant policies that provide guaranteed rates to policyholders,” a team of Moody’s credit analysts wrote in a research note to clients.
Hold the Happy Phone
Although the consensus was that the 0.25 percent increase portended better bond returns, the real world intervened.
As gas prices fell and China’s stock market unraveled like a cheap, ugly Christmas sweater from that country, investors rushed the long-term bond window. So instead of rising, bond yields have dropped since the Fed raised its rate.
The worldwide web of distressing news (did we mention the North Korean atomic bomb?) and its effect on the economy may also still the Fed’s hand on the interest rate at its next meeting. Bloomberg projected only a 43 percent chance that the Fed would raise the rate during its March meeting.
But what goes down eventually bounces back up, so if the economy overcomes the early winter blahs, perhaps the Fed will reach for the rate knob again by June.
New Purchasers Will Benefit More
In that case, the band will strike up again. Once again, new life insurance and annuity contract holders will fare better than buyers who bought a year ago because the contract will pay more, Johnson said.
Millions of people in the market want annuities to generate guaranteed income, but some advisors have found it hard to pull the trigger on an annuity purchase because terms haven’t been that attractive and carriers have been gradually ratcheting back on benefits.
“The deals out there for annuities are not very good, so for potential policyholders and annuitants, rising rates are good news,” Johnson said.
The Fed has flummoxed analysts over the past two years. In late 2014, many market watchers were expecting the Fed to raise rates. It didn’t.
But unemployment was higher then. The November 2015 unemployment report pegged the figure at 5 percent, down from 5.8 percent the previous November and 7.2 percent in November 2013, according to the Labor Department.
Unemployment is half what it was — 10 percent — in October 2009, five months after the nation had officially emerged from recession.
Among the only buyers inconvenienced by the rising rate environment are life insurance policyholders and annuitants who bought in the past five or six years: their policies became more valuable as interest rates fell and gradually paid out less and less.
Long-Term Care Insurance Could Also Get a Lift
The long-term care insurance business also may get a lift from the interest rate increase. That’s according to LTCi executive Jesse Slome.
He foresees a time when rates on newly issued LTCi policies actually may decline from then-current rates.
That won’t happen this year, because the Fed’s recent move was a modest 0.25 increase on short-term interest rates, said Slome, who is executive director of the American Association for Long Term Care Insurance (AALTCI).
More increases will be needed — especially increases to 3 or 4 percent or higher on long-term interest rates — in order for LTCi carriers to reconsider pricing direction, Slome told InsuranceNewsNet.
The long-term rates — currently hovering a little above 2.5 percent — need to be comparable to those before the last recession, in the range of 4 to 5 percent, he said.
Even a 1 percent increase in long-term interest rates could make a difference, he said. AALTCI data indicates that such an increase could translate into a 10 percent to 15 percent decline in LTCi premiums, if other conditions are favorable.
But even in the interim, Slome sees “a glimmer” of positive news in the Fed’s rate action.
If short-term rates continue to rise incrementally, he said, that may enable LTCi carriers to keep rates where they are on new policies. This curtailment of LTCi price increases on new business would introduce important financial stability into the pricing environment, he said.
In addition, the slow but steady increases would enable carriers to invest maturing money and new money coming in at higher rates. That would enhance both profitability and stability, Slome said. The ripple effect “would be an increased likelihood that today’s LTCi carriers will stay in the business rather than leave.”
The thing for LTCi professionals to focus on for now is that “the interest rates are rising, and that things (in the market) could change pretty quickly if this continues,” Slome said.
By quickly, he means in a couple of years, not months. If long-term interest rates go up to, say, 4 percent in a few years, it’s conceivable that new carriers may come into the market or former LTCi carriers may think about re-entering the business, he said. “The global economy may attract players too.”
New carriers won’t have business on the books supported by reserves from the lower-interest era, he pointed out. This may spur them to compete for business by pricing their policies below the rates of the then-current carriers.
If that happens, existing carriers might start cutting their rates too, he said.
Product Change Also Needed
The LTCi market then may enter a period of expansion. This would be all the more likely if LTCi carriers were allowed to use an increasing premium price structure, Slome contended. “Some carriers have proposed this but the regulators won’t allow it, at least not so far.”
When LTCi first came out, the target market was for people in their 70s, and the coverage was primarily to pay for nursing homes, he said. That’s when the level premium structure was established.
But today’s stand-alone policies cover more than nursing home care, and carriers are increasingly trying to sell to younger people in their 60s and 50s. However, requiring a level premium for 20 or more years doesn’t allow carriers to adjust to unforeseen market conditions, Slome said.
If LTCi carriers were allowed to issue “increasing premiums” or “step-up premiums” with their LTCi policies, that would help stimulate more development and expansion in the market, he predicted.
Whatever happens with interest rates, he said, “the current products will still have to change.”