In a low-interest-rate environment, the basic mechanics of a life insurance company’s General Account do not work. This is because low-interest-rate environments cause spread compression between the General Account investment return and the guaranteed, fixed benefit payments supported by these assets.
Over the short term, spread compression is part of doing business for life insurance companies. However, the current prolonged low-rate environment presents a significant challenge for all life insurance company asset/liability management teams.
As I will discuss in future posts, a continued low-rate environment, the misrating of investment-grade corporate bonds, foreign insurance companies chasing yield in the American markets without hedging the currency risk, and a potential drop in the value of the dollar pose a systemic risk to our markets.
Life Insurance Company Assets – General and Separate Accounts
To simplify our understanding of life insurance company assets, it helps to set aside regulatory capital requirements. Having done this, life insurance company assets essentially consist of policy premiums. Obviously, as an insurance company grows, its assets include both premiums and the returns earned on investing these premiums. After receipt, an insurance company invests policy premiums in either their General and/or Separate Accounts. General and Separate Accounts differ in the nature of the obligations for which the assets are being held and invested.
General Accounts support contractual obligations for guaranteed, fixed benefit payments. This includes products like fixed annuities, whole life insurance policies, and GICs. Separate Accounts support liabilities associated with investment risk pass-through products. This means the owner of the product bears the investment risk. This includes products like variable annuities, variable life insurance, and certain novel pension products.
Therefore, as a result, General Accounts hold the majority of life insurance company assets. According to the most recent ACLI insurance statistics, General Account assets totaled $4.4 trillion. In comparison, Separate Account assets totaled $2.7 trillion in 2018.
State insurance and securities laws allow Separate Accounts to be invested in common stocks and other comparatively riskier assets. Whereas various regulations generally require General Account assets to be invested more conservatively.
Life Insurance Company General Account Bond Holdings
Bonds are publicly traded debt securities. As of 2018, bonds represented 48% of life insurance company assets. The total value of these bond holdings is approximately $3.5 trillion. Bond holdings in Separate Accounts were only $399 billion in 2018. By comparison, bond holdings in general accounts amounted to $3.1 trillion in 2018.
This means that bonds make up 70% or $3.1 trillion of the $4.4 trillion in life insurance company General Account assets. This is a significant allocation, and life insurers theoretically bear this investment risk themselves. However, in reality, this investment risk is likely born by policy beneficiaries.
The bonds that make up these General Account holdings are issued by a variety of government and corporate organizations, including domestic and foreign corporations, the U.S. Treasury, U.S. government agencies, and state, local, and foreign governments.
Within these General Accounts, long-term U.S. Treasuries totaled $151 billion, U.S. government obligations $52 billion, and foreign government bonds $95 billion. Bonds issued by U.S. states, territories, and political subdivisions equaled $49 billion. Bonds issued for revenue, assessment, and industrial development totaled $125 billion.
“Unaffiliated Securities” make up the majority ($2.1 trillion, or almost 70%) of life insurance company General Account bond assets. “Unaffiliated Securities” largely means U.S corporate debt. Therefore, the majority of life insurance company General Accounts are invested in U.S. corporate debt.
Life Insurance Company General Account Bond Portfolio Maturities
Bonds have limited lives and expire on a given date, called the bond issue’s maturity date. ACLI statistics show 62 percent of General Account bond assets have a maturity of less than ten years. This shorter near-term maturity reflects the life insurance company’s projected liabilities.
Corporate bonds represent the largest component of life insurance company General Account assets at almost 70 percent. Consequently, based on ACLI bond maturity statistics, life insurance company General Accounts have the largest portion of their assets invested in U.S. corporate debt with maturities of 10 years or less.
How Life Insurance Companies Make Money on Their General Account Policies
Warren Buffet generally explained the concept of how insurance companies make money in his 2002 Berkshire Hathaway Shareholder Letter. Mr. Buffet stated that: “[t]o begin with, float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss,” which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money.”
Life insurance companies execute the strategy described by Mr. Buffet, as follows: They derive their profits from the spread between their General Account earnings and what they credit as interest on insurance policies. For simplicity’s sake, Profit = General Account return – guaranteed interest credited on policies.
What is a Prolonged Low-Rate Environment?
A low-interest rate environment occurs when the risk-free rates of interest set by central banks are lower than the historic averages for a prolonged period of time. In the United States, Treasury Security rates generally determine the risk-free rate.
Most of the developed world has experienced a low-rate environment since 2009 as central banks cut interest rates to effectively 0% in order to stimulate economic growth and prevent deflation. This has been referred to as quantitative easing, or QE. The generic purpose of lowering interest rates is to stimulate economic growth by making it cheaper to borrow money to finance investment.
On December 19, 2018, the Fed raised interest rates for the fourth time in 2018 and the ninth since the Fed began raising rates from near-zero in 2015. The Fed raised the benchmark short-term interest rate to a range of 2.25% to 2.5%. However, the Federal Reserve cut interest rates 3 times in 2019. Reversing nearly all of 2018’s rate increases as “uncertainty from President Trump’s trade war and slowing global growth continue to pose risks to the United States economy.” The benchmark short-term interest rate has now fallen to 1.5% to 1.75%. Therefore, we are currently mired in a prolonged, 11-year low-interest-rate environment.
What is the Average General Account Policy Crediting Rate?
Over the past 75 years, the average return of an investment that approximates the high-quality corporate yield curve (investment-grade corporate bonds) has been around 6 or 7 percent. Thus, the interest credited on guaranteed products issued by life insurance companies has been in line with this return minus costs, management fees, and a reasonable buffer (profit).
Why Does This Matter?
During times of persistent low-interest rates, returns from General Account portfolios predominated by US corporate bonds might be insufficient to meet guaranteed obligations to policyholders. Life insurance companies typically offer products with guarantees regarding the level of income over the life of the policy. The life of these policies could be 30 years or more. Life insurance companies could be facing a mismatch between assets and liabilities because they wrote a significant portion of these products when the economic outlook appeared dramatically different.
As stated, most life insurance contract liabilities are long-duration contracts. In a low-interest-rate environment, it is challenging for a life insurance company to find relatively low-risk, high-yielding, long-duration assets to match fixed annuities and other products that guarantee a minimum annual return.
Older fixed income insurance products have guarantees that closely match or likely surpass current investment portfolio yields. Consequently, this puts a strain on life insurance companies due to spread compression or negative interest margins.
Over the short term, this economic reality (Loss) is the cost of doing business for a life insurance company. Over the long term, this presents a significant challenge for life insurance company asset/liability management teams and the possibility of systemic risk.
Chasen Cohan, Esq. is the founder of Cohan PLLC. Mr. Cohan is a licensed attorney who also possesses FINRA Series 7 (Registered Representative) and Series 63 (Uniform State Representative) licenses, state insurance licenses, and State Securities Registrations in Nevada, Missouri, and North Carolina. Mr. Cohan is admitted to practice law before the Nevada Bar, all Nevada State and Federal Courts, and the United States Court of Appeals for the Ninth Circuit.
Mr. Cohan’s representative clients have included: Wal-Mart Stores, Inc., Sam’s West, Inc., MGM Grand Resorts International, New York-New York Hotel & Casino, Mandalay Corp., The Treasure Island Hotel and Casino, The Cosmopolitan of Las Vegas, The Mirage Casino-Hotel, South Point Hotel & Casino, American Express, Barclays, US Bank, Wells Fargo, Citibank, and various life insurance companies and service providers.
Mr. Cohan is a Las Vegas native who graduated with honors from UCLA with a Bachelor of Arts degree in Political Science. Mr. Cohan received his Juris Doctorate from the University of Texas School of Law. During law school, Mr. Cohan served as a clerk for the Office of the Texas Attorney General and a Judicial Extern for United States District Court Judge James R. Nowlin.
Clients from global brands and middle-market companies to innovative startups and individuals trust Cohan PLLC to resolve their trickiest legal disputes. Whether that’s litigation in state or federal trial and appellate courts in Nevada; investigations and enforcement actions before government agencies; or mediation, arbitration, and regulatory agency proceedings. Cohan PLLC has litigated hundreds of millions in dollars of claims on behalf of corporate litigants. As a result of this experience, Cohan PLLC has been afforded the opportunity to selectively act as Plaintiff’s counsel on complex, personal injury matters.