Entering a Very Different Decade

What a difference a decade makes.

At the beginning of 2007, after a healthy climb, the yield on the benchmark 10-year Treasury note stood at 4.68 percent.

For insurers that held the super safe 10-year T-note investment until maturity, the investment would have yielded a hypothetical $46,800 annually for every $1 million invested in the financial instrument issued by the U.S. government.

When interest rates plummeted in the wake of the 2008 financial crisis, those 2007 bonds turned out to have delivered a rich yield indeed.

Just how rich?

Fast forward to Jan. 3, 2017, when the yield on the 10-year note stood at 2.45 percent.

Insurers holding a 10-year note issued in 2017 can expect to receive $24,500 annually for every $1 million invested.

As of Sept. 30, life and annuity insurers maintained about 73 percent of their invested assets in bonds, the most secure of which are those issued by the U.S. government, so even the slightest movement in rates on the 10-year Treasury matters.

With interest earned on new fixed income investments coming in below the yield generated by insurers’ investment portfolios, insurers holding the bedrock U.S. government 10-year security aren’t getting the same yield they’ve been living off for the past decade.

Average yields continue to be “unfavorably impacted by the investment of new premiums and portfolio cash flows at rates below the portfolio rate,” Ted Johnson, chief financial officer of American Equity Investment Life Holding Co., said in a recent earnings call.

The average yield on invested assets was 4.47 percent in the fourth quarter, but new money in January was being invested at nearly 4.1 percent, Johnson said.

Over the next two years, interest rolling off Prudential’s investment portfolio will be in the neighborhood of  4 percent to 4.25 percent. But right now Prudential is investing new money only at around 3.5 percent, said CFO Robert M. Falzon.

3 Percent a Magic Number?

To compensate for lower rates, insurers have found higher yields by taking on more risk within their investment portfolios to honor the long-ago promises made to consumers holding life insurance and annuity contracts.

“The low rate environment has compelled life insurer investment managers to re-risk their balance sheets by moving down the credit scale, extending asset durations, and increasing allocations to investments other than bonds,” said Andrew Edelsberg, senior director at Kroll Bond Rating Agency.

Since the financial crisis, with less availability of structured securities and demand for higher yields, insurers have shifted to lower-rated corporate bonds, he said.

Life insurers received some good news in December when the Federal Reserve raised its benchmark lending rate by a quarter percent for the second time in 13 months and Federal Reserve officials hinted then at more hikes to come.

But the question is how high does the 10-year Treasury rate have to go to eliminate what analysts refer to as “drag on spread compression.”

A 10-year Treasury rate of 3 percent or thereabouts would eliminate the drag and spread compression. This is a big deal as it potentially affects a company’s financial position to the tune of hundreds of millions of dollars over many years.

“We want to get to the point where the roll-off in the portfolio is not creating further drag on the overall yield by virtue of where we can invest,” Falzon said.

A 10-year Treasury rate of 3 percent is “probably not a bad benchmark,” said Michael Smith, chief financial officer of Voya Financial.

Credit spreads are also a factor.

Assuming spreads are held constant across asset sectors, a 10-year Treasury note with a rate of 3 percent would be “about where we would hit our breakeven on reinvesting,” said Steven A. Kandarian, CEO, president and chairman of MetLife.

Industry experts say it will be another year and perhaps well into 2018 before interest generated from new money invested in U.S. government securities begins to deliver the kind of yield that insurance executives say they want.

“You can’t simply flush out your portfolio and replace it with entirely new stuff,” said Mary Pat Campbell, vice president of insurance research with Conning & Co.

Slowly Rising Rates Good All Around

Not that anybody is complaining about rising rates.

Insurance companies hope they are at the dawn of an ideal scenario: a period of slowly rising interest rates boosted by a robust equity market. For the moment, fixed income and equity markets appear to be delivering precisely that.

Courtesy of the “Trump effect,” the stock market soared past the 20,000 mark for the first time earlier this year.

The Federal Reserve’s rate hike in December was the second quarter-percent increase in 13 months, a recognition that the nation’s economic activity is on a gradual rise.

A slow rate increase allows insurers to adjust and match their assets and their liabilities without the risk of policyholders surrendering their insurance contracts in exchange for new policies with a higher rate, industry experts say.

Slowly rising rates alleviate more than just “margin compression” for insurers.

Higher rates allow insurers to offer more flexibility to consumers with interest-sensitive life and annuity products. Insurers are already taking advantage of that by raising crediting rates.

InsuranceNewsNet Senior Writer Cyril Tuohy has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected].
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