The dramatic decline of the 10-year U.S. Treasury yield to historic lows in 2020 raised concerns in the life insurance industry about the increased likelihood of lower-for-longer interest rates and companies' value propositions. While inflationary risks have risen because of increases in consumer prices--prompting the question of whether the Fed will raise interest rates--in our base case, we expect a lower-for-longer interest rate environment. S&P Global economists' base-case scenario calls for an average yield on 10-year U.S. Treasury notes of 1.7% in 2021 and 2.2% in 2022. But why the big deal about rates?

Rates Are The Name Of The Game

The life insurance and annuity industry is in the business of offering financial solutions from a protection and retirement standpoint. Generally in the past two decades, insurance companies have offered both protection and savings products, with annuities growing at a faster pace than traditional life insurance given the aging U.S. population and the associated demand for those products (see chart 1).

Chart 1

Insurance companies are able to offer these products because they collect and invest those premiums so they can pay out a future death benefit or a crediting rate to a policyholder's cash value account. If an insurer's premium, investment, and fee income exceeds claims, expenses, and reserve requirements, it makes a profit. We often hear about insurers "earning spread," and generally, spread is the difference between the insurer's actual investment return and its interest credited to the cash value "deposit." Interest rates and corresponding corporate spreads matter because the bulk of an insurance company's earnings are derived from investment returns.

Rates are also important when insurance companies set reserves. The Standard Valuation Law specifies the valuation interest rate that companies must use to calculate the minimum policy reserves (traditional reserves) for their statutory financial statements. Under the law, valuation rates are prescribed and vary by issue year, and they are locked in for the life of the contract.

In 2020, however, the industry fully implemented principles-based reserving (PBR) for certain products, such as universal life, term life, and variable annuities. Under PBR, generally valuation rates used to calculate minimum reserves are determined by the net asset earned rate or projected portfolio rates using prescribed interest rate paths, which contemplate a reversion to a mean interest rate of 3.25%. This was already lowered from an original 3.5% in 2020. The National Assn. Of Insurance Commissioners (NAIC) is in discussions on potentially lowering this interest rate parameter further, which could mean higher reserves in the future.

Finally, rates are important because they form one of the key actuarial assumptions in pricing. When determining how much to charge a customer for the benefits they will receive, either through a death benefit or the crediting rate to the cash value, mortality, lapse rates, expenses, and interest rates are some of the main considerations.

Put simply, rates matter because rates ultimately influence a life insurer's investment returns and earnings, the calculation of the liabilities or reserves, and pricing. If over time those established reserves need to be reevaluated because of lower interest rates, reserves increase and that reduces earnings. If reserve increases are sizable enough that they result in a net operating loss, this could erode capital.

How Low Interest Rates Affect Insurance Companies

Declining rates aren't new for life insurers--in fact, they've been managing declining rates for a few decades now. Ultralow interest rates will weigh on earnings as spread compression continues. The impact will vary by issuer, product suite, capital position, and overall net earnings spread. Companies that hold annuities with guarantees would be the most sensitive to low interest rates. Nevertheless, we think life insurance companies will be able to withstand such headwinds in the coming few years.

We looked at the difference between tabular interest rates on annuity reserves as a proxy for the crediting rates and compared it with the investment yields, 10-year Treasury rates, and 'A' rating level credit spreads (see chart 2). Companies are still in a position where they are earning an investment spread over their minimum guarantees, though that is declining, but this is key: The velocity of low interest rates' impact on investment returns is slow, and we believe insurers have time to adjust. This is mainly because only current premium income--which on average has been about 11.5% of life insurers' total invested assets--and investments that mature are invested at the new money rate. Moreover, companies have been pivoting to less-interest-rate-sensitive products over the years.

Chart 2

We can also see the impact of low rates on the liability side. For statutory reporting every year, companies perform an asset adequacy analysis of their investments' ability to meet liabilities (in general, both traditional and PBR reserves) through cash flow testing, which is the primary tool used to make this determination on the statutory side. The exercise determines whether asset cash flows are sufficient to meet liability demands of current in-force over a wide range of moderately adverse scenarios, such as the New York 7 (see table), over a period until the cash flows are immaterial, which can range from 50 years to sometimes even 70 years.

Traditional reserves were set with locked-in assumption rates--meaning the interest rate used to set the reserve 10 years ago would be the same today, and every year, the appointed actuary, as required by regulation, forms an opinion of the reserve adequacy of the company. If the cash flows of the liabilities and assets result in a negative present value of ending market value of surplus, then the company could post reserves and this affects earnings, and in some cases directly affects total adjusted capital (TAC) through a reduction in asset valuation reserve.

Regulations and requirements differ by state. For example, the New York Department of Services did provide relief to insurers at year-end 2020, after rates took a nosedive in March 2020 with the 10-year Treasury falling to 54 basis points; the regulator only required New York-domiciled companies and those companies licensed to do business in New York to pass scenarios 1-4. The regulator also modified the level scenario (scenario 1) to increase to 150 basis points from the starting 10-year Treasury rate because the current scenarios 5-7, as well as not modifying the level scenario, were viewed to be harsher than moderately adverse scenarios.

As of year-end 2020, rates were lower than in 2019, and companies did need to post reserves--and to a lesser extent than in 2019--but viewing this as a percentage of aggregate capital, we believe the effect was manageable for most companies (see chart 3). We expect companies to feel the impact of cash flow testing through low rates, but largely because the asset-liability reserves required as a result of asset adequacy testing have been under 5% of statutory capital as a whole; we believe this to be manageable for the industry in aggregate.

The larger question is what will happen if regulators no longer view scenarios 5, 6, and 7 as harsher than moderately adverse and require companies to post reserves, because we believe this could pose challenges for some companies. Should the reserve increases be significant, companies may request a grade-in period to allow for a smoother transition for additional reserves over time, and we would contemplate the grade-in period over the outlook horizon in our capital adequacy analysis.

Chart 3

For U.S. generally accepted accounting principles (GAAP) reporting, companies also test the adequacy of reserves through loss recognition testing. To that end, a common approach U.S. insurers employ is gross premium valuation (GPV). As part of this test, insurers calculate GPV reserves based on current experience, which may differ from the assumptions backing their base reserves on the balance sheet. If the GPV reserves are higher than the base reserves (net of deferred acquisition cost [DAC]), then insurers are in loss recognition.

This means they will need to increase their balance-sheet reserves (or at least write down the associated DAC) until base reserves are equal to the GPV reserve. This is usually when insurers report reserve charges on their financial statements, which affects earnings. In our ratings framework, when reserve strengthening occurs with GAAP financials, in most cases, it affects our assessment of fixed-charge coverage and leverage, not necessarily our view of capital adequacy, since the majority of our capital adequacy assessments are based on U.S. statutory financial results.

In August 2018, the Financial Accounting Standards Board announced a change to the accounting standards used under GAAP for certain long-duration insurance contracts: ASU 2018-12, commonly known as Long-Duration Targeted Improvement (LDTI). This is one of the most significant changes in GAAP accounting in decades and becomes effective Jan. 1, 2023. One component of this change is the discount rate used to calculate the reserves. Currently, the discount used to calculate reserves is often based on a company's expected investment yield. Discount rates vary by insurer because investment yields differ based on portfolio allocations.

Under the new standard, insurers will need to use a discount rate based on upper-medium-grade (low-credit-risk) fixed-income instrument yield, which has been interpreted to correspond to the 'A' level fixed-income yield. Any loss or gain related to an interest rate change will flow through accumulated other comprehensive income. Such a change would affect credit metrics such as fixed-charge coverage and financial leverage--again, not necessarily our view of capital, since most capital adequacy assessments are evaluated on U.S. statutory financials. However, we use our adjusted assessment of GAAP equity in our debt-funded double leverage calculations, which do directly affect our view of statutory capital adequacy.

The takeaway is that while low rates are clearly a negative trend, the impact of low rates emerges at a slow pace, and we believe companies can still be profitable and have sufficient capital even in a low-rate environment.

How Insurers Mitigate Low Interest Rates

For an industry that is in the business of taking risks, enterprise risk management is critical, and operating amid low rates is one of the top risks insurers have been managing. Companies have taken the following mitigating measures to navigate a lower-for-longer environment.

Asset-liability management

Asset-liability management (ALM) becomes key in managing prolonged low interest rates as insurance companies seek to match their asset and liability cash flows. Today, we typically see companies tightly matched within roughly one year. However, some companies do have a wider ALM mismatch because the asset duration is shorter than the liability duration, particularly as liability durations extend or become more convex or sensitive amid low rates.

Duration mismatches can cause reinvestment risk because continued low rates subject the company to the risk of investing in lower market rates to support higher cash flows or guarantees. Consequently, those companies that have an ALM mismatch are slowly narrowing the mismatch by investing in longer-duration bonds. Depending on the steepness of the yield curve, longer-duration bonds may not compensate a life insurer for the additional duration risk (specifically, when rates are rising, the value of these assets will correspondingly be more sensitive). However, the Treasury curve has been steepening (see chart 4), and this is a positive trend that will help companies narrow the ALM mismatch.

Chart 4

Gradual investment portfolio shifts into less-liquid and structured assets

Some insurance companies have gradually invested in more illiquid assets in search for yield, such as private placement bonds, mortgages, or alternatives (see chart 5), which on one hand could offer insurers the chance to increase the returns earned on assets, but on the other might weigh on liquidity. We believe most life companies have managed their liquidity well and will continue to do so despite exposure to less-liquid assets, due to a lack of "run-on-the-bank"-type liabilities--this also holds in a low-rate environment where policyholders are not lapsing because they can't get a better rate anywhere else. We account for these less-liquid investments through higher capital requirements per our risk-based capital model framework.

Chart 5

We are also seeing some companies take larger positions in structured securities such as collateralized loan obligations (CLOs), but these are primarily in higher-rated tranches. Based on the NAIC's report on CLOs, 90% of the U.S. insurance industry's CLO holdings are investment-grade ('BBB-' or higher), and 76% are rated 'A-' or higher as of year-end 2019. During the pandemic, these structured investments have shown resilience, but arguably, they were not truly tested because the Federal Reserve effectively provided a safety net through its bond-buying program. Looking at investment losses as a percentage of regulatory TAC (see chart 6), we believe investment losses on the aggregate investment portfolio were manageable for the overall industry.

The pandemic is not over yet, but for 2020, investment losses were still lower than in 2008. Nonetheless, we believe companies with these investment exposures do tend to hold these investments to maturity because of the long-tail nature of their liabilities, and they have the capital buffers to withstand potential volatility in a downturn, based on our analysis.

Chart 6

Product shifts and in-force management

Since the financial crisis, companies have slowly been shifting their products to focus on less-interest-sensitive products. Below is an illustration of how sensitive various products are to interest rates.

Last year, some companies deliberately slowed or even halted sales of certain interest-sensitive products, such as living benefits on variable annuities or guaranteed universal life. We have also seen a slow shift toward products that rely less on the general account and more on separate account products where the investment risk is shifted to the policyholder, such as variable universal life.

Low rates pressure returns on new business, but companies are able to adjust crediting rates and guaranteed income levels to price in the low interest rates. Overall, we believe a company that has a diversified insurance product offering with varying degrees of interest rate sensitivity will be able to manage through a lower-for-longer rate environment better than an insurer that is concentrated in a particular interest-sensitive product, such as long-term care.

In-force management also becomes essential during low rates. Companies have employed interest rate hedging programs, which helped protect earnings and capital in the abrupt decline in interest last year, and these hedges will continue to do so in a low-rate environment. Interest rate hedging programs vary by company and by product, but we have seen some companies elect to effectively immunize their balance sheets from interest rate movements for some products, such as variable annuity living benefit guarantees.

Diversification is also key in managing low rates, and some companies have diversified in the past decade into complementary insurance lines, such as group benefits or voluntary businesses, which, while competitive, are not as interest sensitive while being capital light and able to be repriced in the short to intermediate term. Others have diversified into noninsurance businesses, such as asset management, which is not as sticky as life insurance assets but is capital light and allows insurers to bolster fee income.

Companies also have some levers within products that help manage low rates: We saw dividends lowered for participating whole life products and crediting rates lowered for those annuity or universal life products that are not yet at the guaranteed minimum crediting rate. However, there is only so much life insurers can adjust, because reset crediting rates are at or approaching guaranteed minimum interest rates on in-force business. Furthermore, lower-than-expected lapse rates, especially on older annuity contracts, still have minimum guarantees of 4% or more, tending to squeeze net interest margins.

Which brings us to another aspect of managing interest-sensitive in-force: reinsuring or fully divesting these businesses. We have seen a spate of mergers and acquisitions (M&A) with companies divesting businesses or identifying the need to exit long-duration-asset-intensive businesses. We are also seeing companies on the offense, acquiring interest-sensitive business because they have the capital to deploy. We expect M&A activity to continue in the next two to three years as a result.

Regulatory relief

In December 2020, Congress passed the Consolidated Appropriations Act, which changed a federal tax code law that defined certain life insurance products. Specifically, the law amended the Internal Revenue Code's Section 7702, which defines how policies qualify as life insurance contracts. It further explains how much the cash value of a policy can accumulate without being currently taxed.

In order to qualify as life insurance for federal tax purposes, a life insurance policy must pass one of two tests: the cash value accumulation test or the guideline premium test. The first test ensures the policy's cash value does not exceed the present value of all future premiums, or that the cash surrender value did not exceed a lump sum that was needed to buy the policy. Insurers previously used a 4% interest rate to determine how much that lump sum would be. With the new tax code, insurers can use 2% in 2021.

Under the guideline premium test, a policyholder also cannot pay more premiums than needed to fund the death benefit. That test used a 6% interest rate, whereas the new tax code uses a 4% interest rate. These key interest rates are now variable, meaning they are tied to market rates and can increase as overall market rates increase.

From a consumer's perspective, the new tax code means certain life insurance products give them an opportunity to save more while still reaping the tax benefits of holding a life insurance policy. From the insurance company's perspective, this tax law meaningfully affects participating whole life policies and some segments of universal life policies. For example, the updated tax code enables participating whole life carriers to offer a product that has a lower guarantee on the cash value of the account (at minimum 2%), but that can return more in the form of a dividend if the company's overall investment returns are performing well. This simply allows the insurance company to not depend as much on future investment performance.

Also helping insurers is the NAIC's move to allow states to lower the guaranteed nonforfeiture rate to 0.15% from 1% for new deferred fixed annuity business. The guaranteed nonforfeiture rate is the minimum interest rate guarantee an insurer can use to determine the cash value of a deferred fixed annuity. While 0.15% appears low, life insurance companies can design the product so they can offer rates in excess of the minimum nonforfeiture interest rate, thereby still offering customer value while balancing the insurers' need to operate in a low-interest environment. The updated law now needs to be adopted by each state regulator, so we expect this update to give companies some flexibility in new fixed deferred annuity business in coming years.

Despite Spread Compression, Financial Strength Persists

Lower-for-longer rates thus far have not constituted a capital event. The combination of strong capital buffers and sound risk-management practices has proved effective. While companies did experience some capital declines from the COVID-19-induced recession, these were modest, and we believe capital is well positioned to face a lower-for-longer scenario. Further, capital markets remained open during the crisis and enabled insurers to raise debt and hybrids to bolster capital, and most companies also took actions to conserve capital.

As mentioned, diversification in business profiles through products, geographies, or noninsurance business lines has helped companies navigate low interest rates. However, diversification only helps up to a certain point. For example, if an insurance company diversifies into noninsurance businesses or sheds a significant interest-sensitive block--to help mitigate the impact of low interest rates--to a point where the overall credit profile is no longer influenced by the fundamentals of an insurance company but by that of noninsurance, we could take a rating action.

Undoubtedly, low interest rates will continue to weigh on profitability through spread compression and one-time charges as companies reevaluate their reserves annually. However, we believe companies can still be profitable, despite overall lower returns on equity as an industry. From a consumer standpoint, there is still a protection gap and increasing demographic need for retirement savings products in the U.S., and we believe life insurance companies will continue filling this need and provide customer value, albeit with lower margins, while maintaining their financial strength.

Negative Interest Rates Would Bring Bigger Challenges

Negative rates would be even more challenging for the life insurance industry, since they would exacerbate lower investment yields and higher levels of reserve strengthening. Federal Reserve Chairman Jerome Powell has asserted that negative interest rates are not appropriate for the U.S., but what if U.S. government bond yields turned negative? Negative Treasury rates do not immediately mean negative investment rates for life insurance companies, but they would further lower investment yields and increase the likelihood of reserve strengthening, depending on the length of time negative Treasury rates persist.

We can turn to countries like Germany and Japan, where low interest rates have been a reality and where at times government bond yields turned negative but life insurers have remained profitable. U.S. life insurers would likely continue to invest in less-liquid assets and structured securities in search for yield or for foreign currency-denominated bonds for which yields could be higher. But if negative Treasury rates persist for multiple years, leading to pressure on investment yields and increases in reserve strengthening to a point that they severely hamper growth opportunities, result in negative operating performance, and weaken capital adequacy in our view, we believe the industry's credit quality could diminish.

Gradually Rising Rates Would Provide A Boost

A gradual rise in interest rates would be a positive for life insurance companies, and we believe life insurers' balance sheets are reasonably positioned for such a scenario, since cash flow testing does contemplate some rising rate scenarios (see table above). A gradual rise in interest rates would benefit insurers because they would invest new cash at higher new money rates. This would begin to reverse the steady decline in portfolio yields.

Further, a gradual increase in rates would help companies--particularly those whose liabilities exhibit more sensitivity to interest rates due to their convexity--narrow the ALM mismatch. Additionally, with rising rates, many insurers' products that are subject to disintermediation risk (when customers surrender policies yielding lower rates and move funds into higher-yielding products) have surrender charges or don't allow surrender, which limits policyholders' early withdrawal of deposits.

A rapid rise in interest rates would increase the risk of disintermediation. If insurers have to sell investments amid rapidly rising interest rates to pay a higher volume of surrender values than assumed in their ALM, they could incur realized losses because the market value of bonds will have also declined. Large realized losses would, of course, hurt insurers' profitability and capital--and potentially our ratings. A rapidly rising interest rate scenario is possible but unlikely, in our view, given current macroeconomic fundamentals.