Last Updated: 8/24/2023
Issue: The interest rate environment has a significant impact on many segments of the financial sector, including the insurance industry and especially the life insurance industry. Interest rates, of which there are many, have been in secular decline since the 1980s (Figure 1).[1] But from the time of the 2008 financial crisis and Great Recession (2007–2009) until very recently, interest rates were at historic lows. Prolonged periods of low interest rates negatively affect the financial performance of life insurance firms in multiple ways. In late 2021, interest rates began rising quite rapidly. This change in course is not an automatic fix for the problem of an extended environment of low interest rates, and indeed, other problems can surface with rising rates.
Note: black line represents the long-term trend (exponential).
Source: Center for Insurance Policy and Research/NAIC
Data Sources: Board of Governors of the Federal Reserve System, Series H.15 [historical]
Overview: Low Interest Rates: The financial crisis and Great Recession decreased the demand for loanable funds considerably. Fewer companies wanted to borrow (e.g., issue bonds) to make investments in their productive capacity because sales were declining and expected to decline further. Consumers retrenched on purchases of high-value goods and services for which many buyers obtain a loan, such as automobiles. This decrease in the demand for loans (i.e., money) reduced interest rates.
Further, in an effort to support the economy and financial markets during this time, the Federal Reserve (Fed) dramatically lowered the Federal Funds Rate (FFR) target to between 0% and 0.25%, where it remained until December 2015 (Figure 2, blue line).[2] This policy was specifically designed to lower interest rates to induce consumer and firm borrowing. The FFR is the rate banks charge each other for very short-term loans, so changes in the FFR often have a muted effect on longer-term interest rates. Indeed, following the drop in the FFR to nearly zero in 2008, longer-term interest rates did not fall nearly as sharply. This result is evidenced by the increasing gap between the FFR (blue line) and 10-year Treasury rate (green line) in Figure 2.
Source: Center for Insurance Policy and Research/NAIC
Data Sources: ICE Data Indices, LLC; Board of Governors of the Federal Reserve System; Federal Reserve Bank of New York
Having reached the zero lower bound for the FFR in 2008 and recognizing insufficient downward movement in longer-term interest rates, the Fed began using unconventional monetary policy instruments with the goal of further lowering longer-term interest rates. The Fed's quantitative easing program (“QE”) (2008 – 2012), which consisted of large-scale purchases of long-term government bonds (e.g., ten-year Treasury bonds) and other securities (e.g., mortgage-backed securities), helped to push the benchmark 10-year Treasury yield (green line in Figure 2) down from 4.7% at the start of 2007 to 1.9% at the end of 2011. Further, in 2012, the Fed conducted “Operation Twist” in which it sold short-term Treasury securities, the proceeds with which it purchased longer-term Treasury securities. Operation Twist put further downward pressure on long-term interest rates.
Interest rates on corporate bonds (orange line in Figure 2) largely follow the path of the 10-year Treasury, with the gap between corporate bonds and treasury bonds (green line) due largely to credit premiums. An exception is at the onset of the financial crisis in 2008. While Treasury rates, which are considered the credit-risk-free interest rate, fell in 2008 and 2009, credit premiums on corporate bonds soared, creating a gulf between corporate bond yields and Treasury yields at that time.
Unconventional monetary policies helped to keep longer-term rates like those on the 10-year Treasury bond and corporate bonds at historically low rates, with the 10-year Treasury yield sitting below 2.0% for an extended period. Following the gradual phasing out of these more aggressive policies, the benchmark 10-year Treasury yield moved up to 3.0% but slowly settled to 2.3% by the end of 2015. Thus, even with the ceasing of the Fed’s aggressive monetary policies, long-term interest rates remained historically very low.
In a policy normalization effort, the Fed raised the FFR target range, its key interest rate, in 2015 for the first time in nine years. At their December 2018 meeting, the Fed raised the FFR target for the ninth time since it began raising the target from zero in 2015. The FFR was raised to a range of 2.25% to 2.5%, reaching the highest level since 2008. As seen in Figure 2, longer-term rates (green and orange lines) moved little relative to the FFR with these Fed actions, which were intended to raise rates to “normal” levels. The FFR target range remained at this peak until the July 2019 meeting, when Fed officials lowered the range to 2% to 2.25% percent due largely to a global softening in economic activity (July 2019 FOMC statement).
Longer-term interest rates fell precipitously at the beginning of the COVID-19 pandemic, with the yield on the benchmark 10-year Treasury dropping to an unprecedented low of 0.55% in spring 2020 (Figure 2, green line).
In reaction to a potential coronavirus pandemic, Fed officials called a special meeting on March 3, 2020, when they lowered the FFR target to 1% to 1.25%. Soon recognizing that the COVID-19 pandemic would likely substantially undermine economic activity, at another unscheduled meeting twelve days later, Fed officials lowered the FFR target back to its post-financial-crisis level of 0% to 0.25%, where it remained until March 2022.
Implications of Low Interest Rates for Insurers. The low interest rate environment was a key concern for life insurers because their assets and liabilities are heavily exposed to interest rate movements.
Life insurers keep comparatively large balance sheets, and a substantial share of their assets (over 60% in the aggregate) are interest-earning bonds. With lower interest rates, investment earnings on bonds decline. In an effort to raise investment earnings, some life insurers shifted funds out of investment-grade bonds into inherently riskier but generally higher-earning assets, such as asset-backed securities (ABS), collateralized loan obligations (CLOs), derivatives, and real estate.
In addition, 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 in interest to the customer. Many of these products have a guaranteed rate of return to the consumer, which means the interest credited to the consumer by the life insurer is fixed.[3] All else equal, life insurers’ earnings on these products are higher when market interest rates are higher because the spread is higher. When market interest rates are low, the spread is compressed, and therefore, so are earnings.
Figure 3 shows the spread between investment returns (net portfolio yield) and the guaranteed rates of payout on liabilities such as fixed annuities. The data were sourced from the annual statements of 563 life insurance companies for which reserves represented 96% of total industry life insurance reserves during the period. The data show a compression in the spread between the net investment portfolio yield and the guaranteed interest rate during the financial crisis, when the spread fell from 1.8% in 2007 to 1.15 percent in 2009. Spreads have remained historically low since the crisis, peaking at 1.39% in 2011. But the spread plummeted from 2018 to 2020 following global economic softening, followed by the COVID-19 pandemic. Specifically, the spread compressed to 0.63% in 2020 from 1.1% in 2018. It bumped up only slightly in 2021. Over 2018-2021, total industry reserves increased from about $3.6 trillion to $4.1 trillion (unadjusted for inflation).
Source: National Association of Insurance Commissioners
As a low interest rate environment persists, insurers can lower the terms of new policies (e.g., by lowering guaranteed rates), thereby progressively lowering future pay-outs and mitigating compression of the credit spread.
Data suggest that while the low interest environment created spread compression on earnings, it did not materially impact life insurers' solvency. Statutory valuation law requires insurance companies to perform an annual cash flow testing exercise where the life insurance company must build a financial model of their in-force assets and liabilities. The company must run the financial model for a sufficient number of years, such that any remaining in-force liability at the end of the projection period is not material. Most companies run both a set of stochastically generated (randomly generated from a known statistical distribution) interest rate scenarios (typically 1,000+ scenarios), as well as a set of seven deterministic interest rate scenarios prescribed by state insurance regulators.
Rising Interest Rates. Due to supply chain bottlenecks, substantial increases in deficit-financed government spending, and very low interest rates during the COVID-19 pandemic, as well as other possible factors, the inflation rate began to soar in late spring 2020 from nearly 0% in May 2020 to a peak of 9% in June 2022 before easing modestly afterward.
In an effort to break the surge in inflation, the Fed began to raise rates in March 2022 with an initial increase of 50 basis points (March 2022 FOMC Statement) (Figure 2).[4] Since then, increases in the FFR have accelerated with multiple increases of up to 75 basis points in every FOMC session. In addition to any influences from Federal Reserve action, long-term interest rates rise with inflation because the real value (i.e., the purchasing power) of interest earnings declines, as does the real value of the investments themselves.[5]
Implications of Rising Interest Rates for Insurers. As noted above, the financial performance of life insurers generally improves with higher interest rates. As their existing bonds mature, they will be replaced by bonds with higher interest earnings. However, a significant amount of time may elapse before this process meaningfully affects life insurers’ financial performance. Most life insurance policies and retirement savings products offered by life insurers, for which the expected future payouts are liabilities on the balance sheet, are in force for many years. Because life insurers try to match the duration of their assets with the duration of their liabilities, many of the bonds they hold are long-term bonds, and they are usually held to maturity. Thus, the bonds obtained during a period of low interest rates would ostensibly be held on insurer balance sheets for an extended period of time. For some, many years must pass before the bonds reach maturity and can be exchanged for higher-interest-earning bonds.
An exception is the yield on investments with floating interest rates; that is, interest rates tied to a benchmark rate, such as the ten-year Treasury bond. Many bank loans, collateralized loan obligations (CLOs), mortgage loans, and residential mortgage-backed securities (RMBS), all of which are held by insurers to varying degrees, have floating rates, and the interest earned on these assets will rise along with increases in the benchmark interest rate.
Insurers cannot increase earnings by selling existing low-yield bonds and using the proceeds to purchase recently issued, higher-yielding bonds. The reason is the existing low-yield bonds must be sold at potentially heavily discounted prices. The resulting capital losses would offset the benefits from purchasing a higher-yielding bond.
Another benefit of higher interest rates is the net spread of insurer portfolio earnings over guaranteed interest on annuities and some cash-value life insurance (shown in Figure 3) will increase, resulting in greater earnings margins. However, this benefit to life insurers of a higher spread is likely to be diminished by increased policy lapses. That is, some customers will withdraw annuities or retire cash-value life insurance policies in hopes of securing higher yields elsewhere. These withdraws would depress the earnings life insurers would gain from a higher spread on these products.
Changing interest rates also affect insurers through portfolio revaluation effects. Rising interest rates decrease the value of existing, lower-earning bonds in life insurers’ portfolios. Long-term bonds and other interest-rate-sensitive investments are affected more than shorter-term investments, and life insurers tend to hold long-term bonds. The decrease in market value of existing bonds does not reduce the insurers’ statutory capital position because the bonds are reported at book/adjusted carrying value.[6] Further, life insurers typically hold bonds to maturity because of the need to match the timing of asset returns and policyholder claims, which is often a challenge in any interest rate environment. Therefore, these capital losses typically are not realized. As a higher interest rate environment persists, lower-yielding assets mature and can be replaced with higher-yielding assets.
Rising interest rates also can affect life insurers' liquidity. Liquidity is the ease with which assets can be converted to cash. Liquidity management is critical for life insurers. As part of asset-liability management (ALM), life companies 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 be badly mismatched, exposing insurers to losses from potentially pressured asset sales, for which they would receive market value, to meet current obligations to policyholders. Moreover, if a significant volume of policies lapses and annuities are withdrawn to take advantage of rising yields, liquidity demands would increase.
Finally, insurance companies seeking to issue bonds or roll over existing short-term debt may face substantially higher borrowing costs. The higher interest expenses would put downward pressure on profitability.
Note on the London Interbank Offered Rate (LIBOR). Some life insurers have products and services linked to a benchmark interest rate known as the London Interbank Offered Rate (LIBOR). In 2017, the United Kingdom’s Financial Conduct Authority, which is the government entity responsible for regulating LIBOR, indicated that it would no longer require banks to submit rates after 2021. Beginning January 1, 2022, 1-week and 2-month U.S. dollar (USD) LIBOR rates were no longer published (the Valuation Manual does not reference these rates). Beginning July 1, 2023, all USD LIBOR tenors will no longer be published.[7] The sunsetting of LIBOR presents challenges for life insurers that have floating rate debt with the interest rate based on LIBOR or derivative securities (particularly credit default swaps) linked to LIBOR. They will need to move toward an alternative rate for these assets, established by the Alternative Reference Rates Committee (AARC) (Federal Reserve Bank of New York) to be the Secured Overnight Financing Rate (SOFR), which is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.
The AARC has multiple working groups charged with ensuring a successful transition from dollar-denominated LIBOR to SOFR. The NAIC has made changes to its Valuation Manual to replace the use of LIBOR in determining prescribed swap spreads with SOFR for use in year-end 2022 and onward. The NAIC’s Life Actuarial (A) Task Force, its associated subgroups, and other relevant committees, task forces, and working groups are actively monitoring developments around the sunsetting of LIBOR and addressing relevant regulatory issues, including accounting principles and securities valuation.
Status: The NAIC has been actively monitoring the interest rate environment.
Interest rate scenarios provide a good set of stress tests to help ensure life insurance companies have well-matched asset and liability cash flows and/or have established additional reserves that are available to cover any interest rate or reinvestment rate risk embedded in their balance sheets. The Standard Valuation Law (#820) requires life insurance companies to post additional reserves if the appointed actuary determines a significant amount of mismatch exists between the company's asset and liability cash flows.
The NAIC currently is working to implement a new Economic Scenario Generator (ESG) for use in life insurance and annuity reserves and capital. The new ESG is provided by a third-party vendor, which was selected from six candidates following a request for proposals (RFP). A first field test of the new ESG has been conducted and the results are currently being reviewed and compiled by the NAIC. Once the results have been shared with regulators and interested parties, regulators will make decisions on a new iteration of the ESG for an additional industry field test.
The NAIC pulled additional reserves and liabilities reported by companies at year-end 2020. The life insurance industry posted an additional asset/liability cash flow risk reserve of $18.6 billion.
[1]Although they often move in tandem, numerous interest rates exist. The tandem movement of interest rates, or overall interest rate trend, is determined largely by the interplay of the demand for and supply of money, or more specifically, loanable funds. However, interest rates can be affected by policy intervention, particularly the policy initiatives of the Federal Reserve. At any point in time, interest rates vary across individual securities and loans due to differences in credit risk (greater credit risk adds a premium) and term (usually, a premium is earned for longer-term debt).
[2]The Fed does not “set” interest rates other than its own discount rate, which is the rate the Fed itself charges commercial banks for loans. Rather, for the FFR, its key policy rate, the Fed sets a target range (lower and upper limits), and the Federal Reserve Bank of New York buys and sells short-term Treasury securities as necessary to keep the FFR within the target range set by the Federal Reserve’s Federal Open Market Committee (FOMC).
[3]These credits (payments) can be variable but are more commonly fixed (guaranteed). Fixed annuities, whole life insurance, and guaranteed universal life insurance are examples of products that are credited with a fixed rate of interest. For products such as variable universal life and variable annuities, interest credited to the consumer varies with the life insurer’s investment performance. Term life insurance policies do not have cash value.
[4]A basis point is 1/100 of one percent.
[5]The nominal interest rate; that is, the posted (or observable) interest rate (shown in Figures 1 and 2), is the sum of the real rate of interest and the rate of inflation. Thus, if the real interest rate is unchanged, the nominal interest rate will rise in tandem with inflation. The real interest rate is the purchasing power derived from interest earnings or paid out by the borrower.
[6]A book/adjusted carrying value (BACV) is the cost paid for acquiring an asset less depreciation, amortization, or impairment costs applicable to the asset. The market value is the value the asset would realize in a public securities market.
[7]The tenor is the length of time remaining in the life of a financial contract, such as a bond. In contrast, the maturity of the bond refers to the length of the contract upon its inception. Tenor is particularly important in credit-default swaps.
The NAIC has been actively monitoring the interest rate environment.
Interest rate scenarios provide a good set of stress tests to help ensure life insurance companies have well-matched asset and liability cash flows and/or have established additional reserves that are available to cover any interest rate or reinvestment rate risk embedded in their balance sheets. The Standard Valuation Law (#820) requires life insurance companies to post additional reserves if the appointed actuary determines a significant amount of mismatch exists between the company's asset and liability cash flows.
The NAIC currently is working to implement a new Economic Scenario Generator (ESG) for use in life insurance and annuity reserves and capital. The new ESG is provided by a third-party vendor, which was selected from six candidates following a request for proposals (RFP). A first field test of the new ESG has been conducted and the results are currently being reviewed and compiled by the NAIC. Once the results have been shared with regulators and interested parties, regulators will make decisions on a new iteration of the ESG for an additional industry field test.
The NAIC pulled additional reserves and liabilities reported by companies at year-end 2020. The life insurance industry posted an additional asset/liability cash flow risk reserve of $18.6 billion.