Federal Reserve Bank of Chicago/The sensitivity of life insurance

Federal Reserve Bank of Chicago/The sensitivity of life insurance firms to interest rate changes Kyal Berends, Robert McMenamin, Thanases Plestis, and Richard J. Rosen Introduction and summary The United States is in a period of low interest rates following the Great Recession, which lasted from late 2007 through mid-2009. And the Federal Reserve re- cently reaf fi rmed expectations for a lengthy period of low rates, likely to last at least through mid-2015. 1 Low interest rates are expected to reduce the cost of investing in the United States. In turn, increased levels of investment are expected to decrease unemployment over time—an objective that is consistent with the maximum employment component of the Federal Reserve’s dual mandate. 2 While a prolonged period of low interest rates is intended to achieve a broad macroeconomic policy objective, individual sectors of the economy may be more or less sensitive to changes in interest rates. Thus, the impact of the policy on these sectors will vary accordingly. In this article, we focus on the impact of the interest rate environment on the life insurance in- dustry, which is an important part of the U.S. economy and its fi nancial system. Life insurance companies held $5.6 trillion in fi nancial assets at year-end 2012, com- pared with $15.0 trillion in assets held by banks at year- end 2012. 3 In addition to life insurers being large in absolute terms, these companies have special signi fi - cance in that they hold large amounts of speci fi c types of assets. For instance, life insurers held 6.2 percent of total outstanding credit market instruments, including 17.8 percent of all outstanding corporate and foreign bonds, in the United States (see fi gure 1). 4 Life insurers are exposed to the interest rate environ- ment because they sell long-term products whose pres- ent value depends on interest rates. On a fundamental level, the products satisfy two objectives for customers. The fi rst objective is that insurance customers want pro- tection from adverse fi nancial consequences resulting from either loss of life (by buying life insurance poli- cies) or exhaustion of fi nancial resources over time (by buying annuity policies). The second objective is to allow customers to save (generally in a tax-advan- taged way) for the future. Because customers are ex- pected to receive cash from their policies years after they have been issued, life insurers face the challenge of investing the customers’ payments in such a way that the funds are available to satisfy policyholders in the distant future. This feature generally leads life insurers to invest in a collection of long-term assets, mostly bonds. Life insurers generally invest largely in fi xed- income securities because most of their liabilities are Kyal Berends is an associate economist, Robert McMenamin is the team leader for the insurance initiative, Thanases Plestis is an associate economist, and Richard J. Rosen is a senior fi nancial economist and research advisor in the Economic Research Department at the Federal Reserve Bank of Chicago. The authors thank Anna Paulson and Zain Mohey-Deen for their helpful comments and Andy Polacek for research assistance. © 2013 Federal Reserve Bank of Chicago Economic Perspectives is published by the Economic Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and do not necessarily re fl ect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. Charles L. Evans, President ; Daniel G. Sullivan, Executive Vice President and Director of Research ; Spencer Krane, Senior Vice President and Economic Advisor ; David Marshall, Senior Vice President, fi nancial markets group ; Daniel Aaronson, Vice President, microeconomic policy research ; Jonas D. M. Fisher, Vice President, macroeconomic policy research ; Richard Heckinger, Vice President, markets team ; Anna L. Paulson, Vice President, fi nance team ; William A. Testa, Vice President, regional programs ; Richard D. Porter, Vice President and Economics Editor ; Helen Koshy and Han Y. Choi, Editors ; Rita Molloy and Julia Baker, Production Editors ; Sheila A. Mangler, Editorial Assistant . Economic Perspectives articles may be reproduced in whole or in part, provided the articles are not reproduced or distributed for commercial gain and provided the source is appropriately credited. Prior written permission must be obtained for any other reproduc- tion, distribution, republication, or creation of derivative works of Economic Perspectives articles. To request permission, please contact Helen Koshy, senior editor, at 312-322-5830 or email [email protected]. ISSN 0164-0682 48 2Q/2013, Economic Perspectives largely (though not exclusively) fi xed in size. For exam- ple, at the end of 2012, 38.9 percent of life insurance companies’ assets were corporate and foreign bonds. 5 As interest rates change, the values of a life insurer’s assets and liabilities change, potentially exposing the company to risk. Life insurers choose assets to back their liabilities with interest rate risk in mind but may not choose to—or may not be able to—completely balance the interest rate sensitivity of their assets and liabilities. This con fl ict arises in part because assets with maturities as long as those of some insurance liabilities are not always available. Moreover, there is an addi- tional complication. Many life insurance and annuity products have embedded guarantees or attached riders that promise policyholders a minimum return over the duration of their policies. As interest rates decrease, these guarantees or riders can affect how sensitive these products are to interest rate changes. Life insurers are also exposed to interest rate risk through the behavior of policyholders. The interest rate environment affects demand by policyholders for certain insurance products. For example, fi xed-rate annuities can promise a prespeci fi ed return for invest- ments over a potentially extended period. When interest rates are very low, as they are currently, life insurers can only make money on these annuities if they offer policyholders a low return. There is less demand for annuities under these conditions. Also, many insurance products offer policyholders the option to contribute addi- tional funds at their discretion or to close out a contract in return for a predetermined payment (in the latter case, the policyholder is said to surrender the contract; see the next section for details). When interest rates change, it is more likely that policyholders will act on these op- tions. For example, they may contribute more to an annuity with a high guaranteed return when interest rates are low or surrender an annuity with a low return guarantee if interest rates rise signi fi cantly. There is a widespread belief—both among inves- tors and life insurance fi rms—that the current period of low interest rates is bad for life insurance fi rms. The stock prices of life insurers fell in a strong stock market. From the end of December 2010 through the end of December 2012, the Standard & Poor’s (S&P) 500 Life & Health Index, which tracks the stock performance of life and health insurance fi rms in the United States, decreased 9.1 percent, whereas the S&P 500 Index, which tracks the stock performance of the top 500 publicly traded fi rms of the U.S. economy, increased 18.5 percent; all the while, interest rates fell signi fi cantly. 6 Life in- surance executives also appear to be concerned about the low-rate environment. In a 2012 Towers Watson FIGURE 1 Life insurance industry’s aggregate share of assets, 2012 Notes: The percent plotted is the year-end value of the life insurers’ holdings in the specified financial instrument(s) over t he total outstanding value of the financial instrument(s) in the market. Credit market instruments (in red) are an aggregate of the following types of ins truments: corporate and foreign bonds; government-agency- and government-sponsored-enterprise-backed securities (agency- and GSE-backed securities); op en market paper; municipal bonds and loans; mortgages; bank, consumer, and other loans; and Treasury security issues. The dollar values o f credit market instruments do not total because of rounding. Source: Authors’ calculations based on data from the Board of Governors of the Federal Reserve System (2013). percent Mutual fund shares ($159 billion) Corporate equities ($1,534 billion) Treasury security issues ($176 billion) Bank, consumer, and other loans ($150 billion) Mortgages ($347 billion) Municipal bonds and loans ($121 billion) Open market paper ($29 billion) Agency- and GSE-backed securities ($348 billion) Corporate and foreign bonds ($2,178 billion) Credit market instruments ($3,348 billion) 0101520 5