Hidden risk: The impact of financial markets on life insurance

As consumers, we all have a sense of how financial markets and interest rates affect our personal finances. We generally understand that when the stock market rises, it’s usually a positive for our retirement savings. We know lower interest rates are better for borrowing, while higher rates are better for saving and investing.

But when it comes to buying life insurance and annuities, very few consumers understand how the financial markets and interest rate environment impact the risks associated with their purchase.

For example, many consumers don’t realize when they purchase a life insurance policy or annuity, they’re essentially lending their money to an insurance company. Those companies turn around and reinvest the premiums, with a goal of earning returns to pay the promises represented by those policies.

This begs some natural questions: Where is the insurance company investing that money? How much risk are they incurring? And how does that risk impact the price of life insurance and annuities?

These are important questions. And it’s important for consumers and advisors to be informed about the hidden risks that may exist within the purchases they’re making.

Shifting investment strategies

Over the past 20 years, the U.S. has experienced a relatively low-interest rate environment when viewed through a historical lens. This has presented life insurance companies with a challenge. Low interest rates make it difficult for carriers to reinvest premium dollars and earn the returns required to keep prices competitive, while still ensuring their ongoing financial strength and ability to pay future claims.

This environment has led some insurance carriers to shift their investment strategies. In their pursuit of higher returns, some carriers have been willing to take on additional risk. They do this by investing policyholder dollars in newer and, often, more complex investments. In some cases, they may even transfer the added risk to an offshore reinsurer, so they can hold less of a capital cushion against potential losses.

But this hidden risk isn't always transparent to advisors and consumers. Insurance regulators and independent, third-party rating agencies do an excellent job of analyzing insurance companies and flagging potential risks; however, there are occasionally instances in which newer, more complex investments or reinsurance arrangements may not be adequately evaluated.

In those situations, a carrier may not be holding sufficient capital to compensate for the added risk. This increases the possibility of default and, ultimately, the customer not receiving the protection or accumulation they purchased.

Three questions to help identify hidden risk

Given this shift toward riskier, less transparent investments, consumers and advisors must conduct due diligence when making purchase decisions. Here are three questions to ask when evaluating life insurance carriers:

• Does a premium or rate of return seem too good to be true?

The time-tested adage applies here: If something seems too good to be true, it probably is. In the case of life insurance and annuities, if a company is offering lower premiums or higher interest rates, it may indicate they’re doing so by taking outsized risk relative to other carriers. It should be enough of a red flag to dig deeper and ask more questions to better understand how they are able to offer what appears to be such a great deal.

• What themes are present in a rating agency’s report about an insurance carrier?

Three major independent rating agencies evaluate life insurance carriers to provide objective assessments of their financial strength: S&P Global, A.M. Best Co. and Moody’s Investors Service. These agencies routinely issue ratings indicating a carrier’s financial strength, along with a report that supports the rating.

It’s wise for advisors and consumers to look at those reports to gain a better understanding of the rationale behind the rating. Does the carrier have a conservative approach to capital? Does the carrier have a well-diversified business model? Is the carrier in any lines of business or investments that the rating agency flags as having more risk? These reports can offer valuable information that can help determine if there is hidden risk present. Additionally, if one or more of the “big three” rating agencies are not providing a rating for a particular carrier, it could be a signal the missing rating agency may have issued a lower rating or more unfavorable report.

• What types of investments are most prevalent in a life insurance company’s portfolio?

When it comes to the investment portfolio of a life insurance carrier, conservative and transparent is always better. At a high level, advisors and consumers should strongly consider carriers that have an investment portfolio heavily weighted in high-quality bonds. This indicates a focus on the long term.

Diversification is also important. While a portfolio that includes real estate lending, equities and alternatives may contribute to diversification, it’s also important that exposure to those investments is transparent, understandable and limited as a percentage of a company’s overall investment portfolio.

Bottom line: Know what you’re getting into

Today’s economic climate and financial markets make it especially important for advisors and consumers to completely understand what they’re buying. If a carrier’s pricing seems too good to be true, there may be added risk in its investment portfolio. In those instances, do your due diligence before making a purchase.

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Ryan Comins is chief investment officer at Mutual of Omaha. Contact him at [email protected].