November, 2010

In the investment world, stocks are exciting and sexy – bonds are boring and stodgy. Yet, savvy investment pros believe that a better risk/return trade-off exists in the world of interest rates as opposed to the world of stock prices – just ask Bill Gross of PIMCO.

But the flip side is true also, and this strongly impacts life insurance company risks. So much attention has been paid to the risks of guarantees on equity-based liabilities, that the more stealthy risk of very low and possibly volatile interest rates has taken a backseat, even from the major rating agencies.

No other financial challenge is or will have a greater negative impact on the life insurance industry over the next few years than a continued (or even deteriorating) level of low interest rates. Minimum liabilities (i.e., reserves, cash values) are often based on either fixed or past-moving averages of interest rates that haven't caught up with today's low yields. Insufficient spreads can result, harming profits and driving up costs. Insurers with large fixed inforce liabilities are especially susceptible, even if inforce dividends can be adjusted. Hedging costs on equity risks are also more expensive as interest rates drop. And if future interest rates spike too abruptly, following a coiled spring analogy, disintermediation risks abound.

It is not necessary for a sustained Japan scenario to occur to create large interest-based problems for the U.S. life industry. Insurance regulators and insurer product and financial actuaries must get ahead of a possible continued low interest rate world sooner rather than later. Creative product designs and risk management solutions are key.

Tim Pfeifer
President