#59 | Low Rates and Life Insurance

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Since I started writing publicly in May of 2011, I’ve done my best to avoid discussing macroeconomics. If I don’t understand precisely how my car operates, how am I supposed to opine about the aggregate actions of 320 million Americans interacting with unpredictable domestic fiscal and monetary authorities and operating in a global market of 6.9 billion people living in 195 countries, each with its own unpredictable governance? Besides, there are plenty of other far smarter (or far more foolish) people out there willing to talk macroeconomics. Nonetheless, people regularly ask me what I think will happen if the Fed keeps rates low for an extended period of time. I usually do my best to avoid the question. But if Janet Yellen becomes the new Chairman of the Fed, then we’re probably going to be in for a low rate environment for quite a while and the question of how that interacts with life insurance becomes more pertinent. So I’m going to indulge myself in a bit of speculation and don’t take what I’m going to say as anything more than that.

Let’s start off with the baseline assumption that the Fed actually does keep rates low until at least 2017. Life insurers will feel the pinch. There are only two ways that a life insurer can prop up policyholder yields in a 0% rate environment – it takes more risk (credit, maturity, etc) or it uses portfolio crediting. In either case, the eventual consequence of falling rates is falling general account yields. Prepare your clients accordingly by adjusting all illustrations downward. Another 4 years of 0% rates will bleed something like 75bps off of general account yields. Furthermore, the longer we’re in a low rate environment, the longer the lag will be for general account yields to catch up to market rates if the carrier is using portfolio crediting. I’d estimate that every 1 year of benefit from portfolio rates is equivalent to 1.5 years of lag if rates are above portfolio yields in the future. The reality of low interest rates is slow to appear and very slow to disappear.

Most of what I see selling today operates off of the false assumption that life insurers can beat the bond market by a substantial margin over the long-run. That just simply hasn’t happened. Northwestern Mutual dividends have averaged a mere 8 basis points over AAA bonds from 1919 to 2012. And, as we all know, dividends include interest but also expense and mortality improvements. Theoretically, there’s no reason why an insurer investing in bonds should beat the bond market. Even if an insurer makes stellar investment decisions, it starts off with a disadvantage because it pays for overhead, which usually runs between 1-2% of general account assets. Life insurance yields are attractive only in the after-tax universe – courtesy of our unique advantages rather than our prowess as investors.

From a product standpoint, low rates will likely continue to force carriers out of Guaranteed UL and into alternate lines, but not in the way that we’ve traditionally seen. Low interest rates would continue to put pressure on the appeal of any general account product – including Indexed UL. Dividends, crediting rates and indexed caps would all take a beating. More importantly, continued low rates also compound the disintermediation risk inherent in any general account product. Any general account product creates the potential for a run. Bond values move inversely to interest rates. Policy surrender values are never adjusted as a result of the underlying bond values. This hasn’t been a problem because interest rates have been falling for the last 30 years, meaning that carriers buy bonds that have generally only become more valuable over time. But a spike in interest rates will lead to a drop in bond values that isn’t reflected in the cash surrender value. If policy yields lag market returns, then policyholders will have an incentive to move out of the products, particularly if they were buying the contract for its cash value rather than death benefit (as has become extremely common with Whole Life and IUL). One way to hedge this risk is to start selling separate account products that don’t have disintermediation risk. Expect life insurers to start focusing on VUL as a way to diversify their interest rate risk profile. VUL also doesn’t suffer from the same sort of spread compression as CAUL. At the end of the day, insurers need to be well diversified across a variety of product lines in order to weather any interest rate storm. Right now, though, most carriers are heavily concentrated in one of two bets – that rates will rise (VAs, GUL) and that rates will be non-volatile (Whole Life). The rising rate bet appears to be unfolding rather poorly, but at least rates haven’t done anything crazy yet.

Here’s where I may break from the pack. Most people assume that the Fed has a firm grip on interest rates and that its policies create specific outcomes. Traditionally, Fed policies worked within the confines of a functioning market. This time around, though, the Fed is the primary market driver. Its balance sheet has ballooned to almost $4 trillion from $1 trillion in just four years. All of that money has mutilated price signals on value. Money is cheap (another way of saying that interest rates are low) because the Fed has injected trillions of dollars into the market. The problem is that cheap money flows more easily than expensive money. Diners at a buffet aren’t nearly as discriminating about what they choose to eat as diners at an upscale restaurant. All of this cheap money eventually has to go somewhere and I see three primary places – investment, inflation and mal-investment. These three categories coexist, but their mixture is going to determine how all of this mess ends up. Money going to investment obviously is a net positive to us as a society. Money going to inflation is bad because it imposes a host of implicit taxes and arbitrarily reallocates capital. But mal-investment is really bad. Money flowing to mal-investment is like hiring a few million people to dig holes and fill them, which technically increases GDP but obviously does nothing. Mal-investment is, by definition, a bubble. Its price is always disconnected from its value because its price is a function of cheap money, not inherent value. Bubbles always move capital way from productive investments and towards assets rising in the bubble. In my mind, this is the story of 2008. In short, investment is productive capital, inflation is inefficient capital and mal-investment is dead capital. The vain hope of monetary stimulus is that it creates more opportunities for investment. In reality, it mostly flows to mal-investment or inflation. Productive investment is contingent on innovation, not capital.

Ok, there’s actually a fourth option – the Fed injects money to fill in the holes from previous mal-investment and then removes it once actual investment starts. There are at least three problems with this idea. First, cheap money incentivizes mal-investment, so the solution begets the problem. Second, discerning between investment and mal-investment is impossible. No one made that call when housing was booming and crossed the line between the two. And since mal-investment looks like investment until it blows up, then we won’t know for sure until it’s too late. Third, removing liquidity means reselling the mal-investment runoff that was purchased previously. For the Fed, that means selling lots of MBS and Treasuries. Recent auctions have essentially proven that there’s no real market for Treasuries and the market for MBS exposure is still pretty weak (investors seem to be preferring direct exposure these days). So unwinding the balance sheet is going to be a real bear. The Fed hasn’t ever had to do it before. Will it work? No one knows. If it doesn’t, then all of that cash is going to hang around the economy and undiscerning buffet diners are going to be scooping up heaping piles of delicious-looking mal-investment, which will manifest itself as yet another asset bubble. If they don’t, then we get inflation. The only way to win is to invest in things that actually provide benefits to society. Sorry, Zynga and Solyndra, you don’t qualify.

The punchline for the life insurance industry is that virtually every general account product our industry sells is chock full of interest rate bets. If you think the Fed has a handle on the situation, then you should feel fairly comfortable. If you’re skeptical that someone who can’t explain how a car works can divine the mysteries of macroeconomics, then you should prepare for a wild ride. I fall in the latter camp. Low rates do not bother me. Low rates are a clamp on a spring. The longer they stay low, the tighter the spring. Once the Fed can no longer contain the spring, it’s going to bounce and we have no idea where it will go. Our products are going to interact with that spring in unpredictable ways. If you’re building a life portfolio with an eye to that risk, then there’s one really good option for you to consider – diversification. Each client should have a robust portfolio of products. That’s the only way to manage uncertainty and, in my opinion, there’s way more uncertainty than most folks are acknowledging.

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