Life insurers weigh pros and cons of higher interest rates

Life insurance companies in the United States are exposed to risks from soaring interest rates, the Federal Reserve has said, as runaway inflation prompts further rate hikes. The warning comes after the world’s most prominent central bank raised its benchmark interest rate half a percentage point two weeks ago, the biggest increase since 2000.

The debate revolves around how life insurers such as Northwestern Mutual (US: NWE) or New York Life will get away with it if customers decide to take advantage of higher interest rates by mass surrendering the policies. Life insurance holders in the United States can get a cash payment to excite their policy, which can also be done to avoid the cost of maintaining the insurance.

Of particular concern to the central bank was how life insurers would fare if further interest rate hikes caused policyholders to surrender their contracts at higher than expected rates. “If the increase in redemptions is large enough, it could put downward pressure on the financial performance of life insurers,” the Federal Reserve said.

It is in this area that the regulatory differences between UK/EU and US insurers become most apparent.

The trend in the U.S. life insurance industry is for balance sheets to be increasingly stretched with interest rate sensitive illiquid assets, while investing heavily in corporate bonds, guaranteed loans and commercial real estate debts. Low interest rates since the 2008 financial crisis have seen debt levels involving this type of debt hit a 20-year high.

In the UK, the situation is slightly different. Although the Bank of England raised its interest rate to 0.75% in March, UK life insurers will not face the same balance sheet volatility as their US counterparts. A Aviva (AV.) spokesperson told the Investor Chronicle that the rise in interest rates could “have a positive impact on the financial situation of British insurers”. However, the spokesperson noted that rising interest rates would force insurers to “take a more cautious approach to high-risk investments.”

The main difference is that US life insurers offer annuities and other products that include minimum guarantees. In the UK, profit on savings from life insurance products is linked to the return insurers earn on their underlying invested assets – so you don’t have any surprise obligations that can’t be met .

Additionally, UK Solvency II rules require the duration of the asset to match the calculated duration of the liability, which also keeps the volatility of the asset low. Matthew Connell, director of policy and public affairs at the Chartered Insurance Institute, said UK insurers operated in a very different way to US businesses. “People invest in [in the UK] life insurance because they want to protect their loved ones,” he said.