Pace of Rate Hikes May Determine Benefit to Annuity Sellers

By John Hilton

The Federal Reserve is in an aggressive mode when it comes to interest rates and combating inflation. That could mean good news for annuity sellers.

Or not.

"What I would say there is rising interest rates are kind of a double-edged sword," said Mike McCarthy, vice president, distribution strategy for Prudential. "Slow and steady is good. But fast and furious could be bad and potentially disastrous."

McCarthy spoke Thursday as part of the panel discussion titled, "Rising Rates: Panacea, Problem, or Both?" at the Insured Retirement Institute's annual conference in Washington, D.C.

'Know Who You're Doing Business With'

The Fed released a report recently, McCarthy noted, that looked at two different scenarios: slow sustained rates increasing over time, and a short-term significant rise in rates.

The former scenario is considered good for insurance companies and their earnings. It also dissuades them from looking at investing in potentially illiquid highly interest-rate sensitive investments, McCarthy explained.

But the rapid rate increases brings the "potential of having large amounts of life insurance policies surrender, annuity contracts surrender, because investors are out there have an opportunity to drive higher yields elsewhere," he added. "So, what I would say there is make sure you know who you're doing business with."

Earlier this month, the Fed raised benchmark borrowing rates by half a percentage point, the second increase of 2022 as inflation runs around a 40-year high. In an interview with The Wall Street Journal this week, Fed Chair Jerome Powell vowed to hike rates again and again if needed to bring inflation down to its 2% target.

“We will go until we feel we’re at a place where we can say financial conditions are in an appropriate place, we see inflation coming down," Powell said.

McCarthy cited two other reports that paint a troubling picture for insurers if rates rise too quickly:

An April Moody's report studied the impact of a 3% rise in long-term interest rates. The report pointed out that the leverage ratio -- the ratio of assets to equity -- is currently at a 20-year high among life insurers, McCarthy noted. That ratio stands at 12-to-1, compared that to the P&C channels, where it's 3-to-1.

"It's significant," McCarthy said. "Over the last 10 years, as insurance companies have stretched for yield, what they've said is that more and more of their portfolios are going into illiquid investments like CLOs [collateralized loan obligations] and is going into commercial real estate debt. This stuff is highly sensitive the movements in interest rates."

In October, the International Monetary Fund released "the most ominous" report, McCarthy said. It concluded that a rapid rise in interest rates would cause "massive disintermediation" and could lead to U.S. policy surrenders totaling $550 billion.

Opportunity For Indexed Annuities

The panel agreed that rising rates could open the door for annuities sold with risk-controlled indexes. These types of products will utilize, for example, a heavy bond component in order to remove the risk elements, explained Pete Miller, insurance research strategist with Invesco.

"I think for FIAs [fixed indexed annuities] in particular, that's likely to get substantial share flows in the coming months, quarters, years," Miller said. "Because those products do often utilize these risk-controlled and hybrid indices, I think that's a tailwind for that type of index."

Unlike other fixed-money financial instruments, such as CDs and treasury bills, FIAs offer the opportunity to participate in the stock market. But FIAs have a 0% floor, so owners can never lose money. Fixed products are traditionally more popular in economic downturns.

Fixed annuity sales overall took off in March, coinciding with the first Fed rate increase. Fixed indexed annuity sales were $16.3 billion, 21% higher than prior year, the Secure Retirement Institute reported. Fixed-rate deferred annuity sales increased 10% in the first quarter, year-over-year to $16 billion.

FIA indices normally have a 10- to 20-year "lookback" period to determine performance. In the present environment, that lookback period will make FIA products look more attractive, Miller said. These products are due to change, however, he added.

"The next 10 years look quite different," Miller said. "How do we design a hybrid index or a risk-controlled index where we still need that bond exposure, but it needs to be somehow more thoughtfully designed, maybe more dynamic, somehow have something incorporated that can manage that duration risk?"

InsuranceNewsNet Senior Editor John Hilton has covered business and other beats in more than 20 years of daily journalism. John may be reached at [email protected]. Follow him on Twitter @INNJohnH.