We have been in a low interest rate environment for the last decade. Interest rates have not recovered to pre-financial crisis levels and the normalization from artificially low levels is unlikely until 2018 as illustrated by the huge ($4.6 bn) remaining balance sheet of the Fed.
While not primary driver, low interest rate environment has contributed to drop sales in major life insurance products such as Variable Annuities and General Account products. Although large fixed income allocations help reduce volatility, it becomes more challenging for assets to grow at guaranteed levels in a prolonged low rate environment:
- On the one hand lower interest rates increase cost of capital, reserves from higher present value of expected claims, cost of hedging as options become more expensive
- On the other hand lower interest rates increased difficulty in supporting minimum guaranteed rates in fixed account due to spread compression in general account, and decreased ROEs due to lower net income from higher reserve levels.
Unfortunately, too early expectations after 2009 of rising back up interest rates have pushed most writers to consider growing further and developing more generous thus riskier products at same price, as illustrated by high minimum guaranteed rates and withdrawals (e.g. 5-7% roll-up and guaranteed withdrawal rates, annual / quarterly / daily ratchets for VAs).
However, as interest rates have remained persistently low and volatile, fundamental de-risking measures have been implemented by most life insurers:
- Product designs de-risking: higher fees (M&E and riders); lower benefits (lower roll-up rate, lower frequency of ratchets, lower guaranteed withdrawal rates; stricter asset allocation limits (Higher mandatory minimum allocation to fixed / balanced accounts); restriction in ability of policyholders to “time the market”; restriction in number of equity funds; increased use of “tracker” funds; stricter governance in product approval process; possibility for the insurer to increase fees at discretion.
- Most life insurers have also improved their risk management practices: increased use of volatility hedging; adding macro hedges to protect against steep interest rate drops
Such de-risking has not only provided healthier margins for new business, but has also strengthened life reinsurance markets. But it cannot fully mitigate the impact of persistently low interest rate environment, as illustrated by higher cost of hedging Variable Annuities, and difficulty in supporting rates in fixed account due to spread compression in General Account.
Still further solutions remain in order to survive and thrive in the low rates environment:
- Decelerate distribution of Variable Annuities and General Account sales until interest rates mean-revert to sustainable long term levels is reasonable.
- As persistent low interest rates have increased customers’ concerns about fees triggered drastic changes in their behavior (lower lapse and partial withdrawals), retrieving resiliency in profitability requires to develop customer centric designs within a “rational” framework which balances benefits vs. fees.
- Buyout initiatives which provides compensation to policyholder in exchange for product.
- Develop alternative products such as Fixed Index Annuities which not only suffers less from guaranteed rates thanks to Market Value Adjusters and reset of guaranteed rates after short guarantee periods, but also benefits from Equity upside potential as illustrated by the 75% S&P500 growth since 2013.