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Low Interest Rates

Last Updated 6/8/2021

Issue: The interest rate environment has a significant impact on many segments of the financial sector, including the life insurance industry. Interest rates declined significantly for about 5 years following the 2007-2008 global financial crisis before leveling out at historically low rates (Figure 1). These historically low rates persisted even with monetary policy normalization efforts (movement to a less “accommodative” policy) beginning in 2015, which included a “gradual” increase in the target Federal Funds Rate (FFR) (the FFR is the rate at which commercial banks charge each other for short-term loans). 

Figure 1 

Selected Interest Rates - 2006-2021

Source: National Association of Insurance Commissioners 

Interest rates fell precipitously further at the beginning of the COVID-19 pandemic, with the yield on the benchmark 10-year Treasury (constant maturity) dropping to an unprecedented low of 0.6%. In mid-2021, interest rates returned to near pre-pandemic levels, but those levels were at 50-year lows. Persistent low interest rates are a major threat to life insurance companies, given their rate-sensitive products, such as whole life insurance and annuities, and investments, the large majority of which are interest-earning bonds. 

Overview

Interest Rate Trends: The Federal Reserve (Fed) uses a variety of tools to fulfill its dual mandate of maximum employment and stable prices. The Fed does not “set” interest rates other than its own discount rate. Its primary policy instrument is open market operations, which is the buying and selling of short-term Treasury securities to keep the FFR within its target range. Historically, the Fed has raised its target when the economic outlook is inflationary and has lowered the target rate or range when the economy is soft or in a downturn, such as during a recession. Other interest rates are market-determined outside of direct Fed influence and do not necessarily respond to changes in the FFR, although bank rates often do. 

In an effort to support the economy and financial markets during the financial crisis and 2007 – 2009 Great Recession, the Fed dramatically lowered the FFR target  to between 0% and 0.25%, where it remained until December 2015. Having reached the lower bound for the FFR (2008), the Fed then began using unconventional monetary policy instruments with the goal of further lowering longer-term interest rates. These tools included the purchase of longer-duration Treasury securities and agency (Fannie Mae and Freddie Mac) mortgage-backed securities. 

The Fed's quantitative easing (QE) program, or large-scale purchases of long-term government bonds and other securities, along with other unconventional efforts, helped to push the benchmark 10-year Treasury yield down from 4.7% at the start of 2007 to 1.9% at the end of 2011. QE occurred in three phases: QE1 (2008), QE2 (2010), and QE3 (2012). Following the gradual phasing out of this bond-buying program by the Fed, the benchmark rate moved up to 3.0% at the end of 2013 before slowly settling to 2.3% at the end of 2015. In 2015 the Fed raised its key interest rate for the first time in nine years. 

At their December 2018 meeting, the Fed raised interest rates for the ninth time since it began raising rates from near-zero in 2015. The FFR was raised to a range of 2.25% to 2.5%, reaching the highest level since 2008. The FFR target range remained at that peak until the July 2019 meeting, when Fed officials lowered the range to 2% to 2.25% percent due largely to a global softening in economic activity. Rates continued to decline through the Fed’s March 3, 2020 meeting, when the range was lowered to 1 percent from 1.25 percent. At an unscheduled meeting twelve days later, recognizing that the COVID-19 pandemic could substantially undermine economic activity, Fed officials lowered the FFR target back to its post-financial-crisis level of 0% to 0.25%, where it has remained as of June 2021. 

Implications for insurers: The low interest rate environment is a key concern for life insurers because their assets and liabilities are heavily exposed to interest rate movements. In particular, their investments are concentrated in fixed-income securities that return interest, largely bonds. Moreover, their liabilities also are sensitive to interest rates. Specifically, many of their products, such as annuities, have a guaranteed rate of return, usually in the form of interest that is credited. Life insurers' earnings  mostly are derived from the spread between their investment returns, which are mostly interest, and what they credit as interest on these consumer products. During times of persistent low interest rates, the spread between interest earned and interest credited is compressed, which not only reduces net income for the insurer, but also puts them at risk of being unable to meet contractually guaranteed obligations to policyholders. 

Changing interest rates also affect insurers through portfolio revaluation effects. Falling interest rates increase the value of existing interest-earning assets in the life insurers’ portfolios. Long-term bonds and other interest-rate-sensitive investments are affected more than shorter-term investments. However, the increase in market value of existing bonds does not improve the insurers’ statutory capital position because the bonds are reported at book value. Further, life insurers typically hold bonds to maturity because of the need to match the timing of asset returns and policyholder claims, which is often a challenge in any interest rate environment. Therefore, the capital gains typically are not realized. Further, as a low interest rate environment persists, higher-yielding assets mature and must be replaced with low-yielding assets. 

Persistent low interest rates also can affect life insurers' liquidity. Liquidity is the ease with which assets can be converted to cash. Liquidity management is critical for life insurers. As part of asset-liability management (ALM), life companies strive to match asset cash flows with  cash outflows to avoid asset-liability mismatch and interest rate risk. During periods of low interest rates, cash flows from assets and liabilities can be badly mismatched, exposing insurers to losses from potentially pressured asset sales to meet current obligations to policyholders. While under conditions of persistent low interest rates liquidity demands tend to decrease as policy-holders are more likely to keep their money in life insurance investment products, such as annuities, due to the previously agreed upon and guaranteed return and limited availability of higher-yielding alternatives. On, the flip side, as interest rates rise, interest-earning policies are increasingly likely to lapse.  

As a low interest rate environment persists, insurers can lower the terms of new policies (e.g., by lowering guaranteed rates), thereby progressively lowering future pay-outs and mitigating compression of the credit spread. For more on the impact of low interest rates on life insurers' and how life insures' counter low interest rates, please see ”CIPR Study on the State of the Life Insurance Industry: Implications of Industry Trends (2013)” and “The Effects of a Low Interest Rate Environment on Life Insurers” (2015) (The Geneva Papers on Risk and Insurance).  

Note on the London Interbank Offered Rate (LIBOR): Some life insurers have products and services linked to a benchmark interest rate known as the London Interbank Offered Rate (LIBOR). In 2017, the United Kingdom’s Financial Conduct Authority, which is the government entity responsible for regulating LIBOR, indicated that it would no longer require banks to submit rates after 2021, likely ending the use and publication of LIBOR. The sunsetting of LIBOR presents challenges for life insurers that have floating rate debt with the interest rate based on LIBOR or derivative securities linked to LIBOR. They will need to move toward an alternative rate for these assets, most likely the Secured Overnight Financing Rate (SOFR), which is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. 

The Alternative Reference Rates Committee (AARC), which was formed by the Fed in 2014, has multiple working groups charged with ensuring a successful transition from dollar-denominated LIBOR to SOFR. The NAIC is considering changes that will need to be made in its Valuation Manual due to this turn in the financial sector. The NAIC’s Financial Condition (E) Committee is actively monitoring developments around the ceasing of LIBOR and addressing relevant regulatory issues, including accounting principles and securities valuation. 

Status: The NAIC has been actively monitoring the low interest rate environment. Indeed, the NAIC tracks the impact of the low interest rate environment on life insurers by tracking the spread between investment returns (net portfolio yield) and the guaranteed rates of payout on liabilities, such as variables annuities (Figure 2). Recently these data were updated to cover the 2006-2020 calendar year. The data were sourced from the annual statements of 545 life insurance companies whose reserves represented 96% of total industry life insurance reserves during the period. The data show a squeeze in the spread between the net investment portfolio yield and the guaranteed interest rate during the financial crisis, when the spread fell from 1.8% in 2007 to 1.15 percent in 2009. Spreads have remained historically low since the crisis, peaking at 1.39% in 2011. But the spread plummeted from 2018 to 2020 following global economic softening, followed by the COVID-19 pandemic. Specifically, the spread compressed to 0.63% in 2020 from 1.1% in 2018. Over that period, total industry reserves increased from about $3.6 trillion to $3.9 trillion (unadjusted for inflation). In 2006, total industry reserves were roughly $2 trillion.  

Figure 2 

Net Spread - Net Portfolio Yield over Guaranteed Interest Rate

Source: National Association of Insurance Commissioners 

The data suggest that while the low interest environment created spread compression on earnings, it did not materially impact life insurers' solvency. Statutory valuation law requires insurance companies to perform an annual cash flow testing exercise where the life insurance company must build a financial model of their in-force assets and liabilities. The company must run the financial model for a sufficient number of years, such that any remaining in-force liability at the end of the projection period is not material. Most companies run both a set of stochastically generated (randomly generated from a known statistical distribution) interest rate scenarios (typically 1,000+ scenarios), as well as a set of seven deterministic interest rate scenarios prescribed by state insurance regulators. The NAIC currently is evaluating a new Economic Scenario Generator (ESG) that they view as a significant improvement over scenario generators currently in use. The new ESG is provided by a third-party vendor, which was selected from six candidates following a request for proposals (RFP). The ESG has yet to be field tested but may eventually (by statute) replace interest rate scenario generators currently in use.  

Interest rate scenarios provide a good set of stress tests to help ensure life insurance companies have well-matched asset and liability cash flows and/or have established additional reserves that are available to cover any interest rate or reinvestment rate risk embedded in their balance sheets. The Standard Valuation Law (#820) requires life insurance companies to post additional reserves if the appointed actuary determines a significant amount of mismatch exists between the company's asset and liability cash flows. The NAIC pulled additional reserves and liabilities reported by companies at year-end 2020. The life insurance industry posted an additional asset/liability cash flow risk reserve of $18.6 billion.