#253 | The End of the Asset Management Era

The typical narrative in the life insurance business is that falling interest rates are an unmitigated disaster for life insurance companies resulting in spread compression, unsupportable guarantees, expense pressure and general malaise. There’s certainly truth in the narrative – and it’s not hard to see the damage. Guaranteed UL product capacity is far more limited than it used to be, even though pricing actually hasn’t increased dramatically in a decade. Many companies have chosen to completely jettison the product rather than price it at fair-market rates, which is actually a sign of how toxic those companies perceive the risks to be. We’ve also seen stalwart insurers exit the business, put themselves up for sale or be spun off in large part because of the havoc wreaked by low rates on their existing blocks of business. From this vantage point, it looks like the end of the life insurance business is nigh.

But that focuses only on the liability side of the balance sheet. For insurance companies that priced their products based on interest rate assumptions that now appear to be as achievable as my dream of becoming a Formula 1 driver, low interest rates are a wrecking ball. Not every life insurer is in that position. For companies with liabilities that were priced with more realistic – or more adjustable – assumptions, there have been some distinct benefits to the prolonged falling interest rate environment. From their vantage point, being a big life insurance company with billions of fixed-income assets under management has arguably been the catbird seat for at least the last decade.

How is that possible? Think back to what you learned in finance class about bonds – when rates drop, prices rise. These price increases are not reflected on the life insurer’s balance sheet as unrealized capital gains. Life insurers use book value rather than fair market accounting for bond holdings. Accessing these unrealized capital gains requires selling an asset and converting it into a realized capital gain which, in some cases, has to be amortized through the interest maintenance reserve. Just how big are bond unrealized capital gains at different insurers? The numbers are staggering. Take a look.

CarrierBook ValueFair ValueUnrealized Gains% of Portfolio% of Surplus
Security Life of Denver9,36210,6001,23813%141%
Reliastar12,51413,9411,42711%93%
Lincoln80,14688,9558,80911%108%
American General98,988109,51310,52511%168%
Brighthouse31,08934,1883,09910%36%
Guardian37,99241,2203,2288%42%
New York Life112,477122,0119,5348%43%
PennMutual8,1978,8746778%34%
Pacific Life53,04257,0974,0558%39%
MassMutual101,906109,3357,4297%39%
Minnesota Life18,07219,2441,1726%37%
Symetra25,86127,4901,6296%76%
Equitable47,60350,6012,9986%37%
Northwestern Mutual159,759168,7298,9706%37%

One way to interpret these figures is that life insurers generally have been 6% and 13% of their total portfolio of bonds sitting off-balance sheet as value that could be accessed if they were to sell the entirety of their holdings. That’s an enormous amount of money. Another way to interpret it is that if unrealized capital gains on bonds were to flow through to the bottom line of the insurer in the same way that unrealized capital gains on basically every other asset a life insurer holds do, then they would augment the company’s surplus by somewhere between 35% and 170%. You might even go so far as to say that life insurers are in a considerably better financial situation than their current capital position would suggest, especially for firms like American General, where unrealized bond capital gains account for a whopping 168% of surplus, or even Lincoln (108%) and Symetra (76%).

The challenge, of course, is that life insurers buy these bonds to pair with their liabilities. A company can’t just sell its appreciated bonds willy-nilly without consequences on the liabilities side. If the liability is a fixed, interest sensitive product like a Guaranteed UL, then reaping the benefits of an appreciated bond today means losses tomorrow if future interest rates don’t increase. If the liability is flexible, like a Universal Life crediting rate or a dividend rate in a Whole Life policy, then the lower yield on the new instrument will result in a lower rate in the long run, assuming the proceeds from the capital gain are spent rather than reinvested.

But that doesn’t mean that life insurers can’t strategically deploy their capital gains – and they definitely do. Take a look at the table below, which shows the same insurers as before but also their realized capital gain proceeds as a percentage of the overall bond portfolio.

CarrierBook ValueFair ValueUnrealized GainsRealized GainRealized Yield
American General98,988109,51310,5256030.61%
PennMutual8,1978,874677470.57%
Symetra25,86127,4901,6291300.50%
Northwestern Mutual159,759168,7298,9706400.40%
Equitable47,60350,6012,9981800.38%
Guardian37,99241,2203,2281370.36%
Brighthouse31,08934,1883,099930.30%
MassMutual101,906109,3357,4291960.19%
Reliastar12,51413,9411,427240.19%
Minnesota Life18,07219,2441,172280.15%
New York Life112,477122,0119,534980.09%
Security Life of Denver9,36210,6001,23880.09%
Pacific Life53,04257,0974,055420.08%
Lincoln80,14688,9558,809270.03%

Again, the figures are staggering. American General, for example, pocketed a whopping $603 million in 2019 just from capital gains on its bonds. As a percentage of the total portfolio, PennMutual wasn’t far behind American General at 0.57%. Where do all of these gains go? In another curious bit of life insurer accounting, they don’t go directly to Net Income. Instead, they go to the Interest Maintenance Reserve (IMR), a reserve designed specifically to amortize the gains over time into the net income of the company. American General, for example, has over $1.6 billion sitting in the IMR as of the end of 2019. The IMR itself contributed about $123M to the Net Income of the firm in 2019. The IMR essentially allows the effect of realized capital gains to be smoothed out over time, providing a steady flow of benefits to the firm that appear in Net Income. A carrier selling an appreciated asset is making a trade – future yield for future net income.

Life insurers with enormous unrealized capital gains lying dormant off of their statutory balance sheets – which is to say, all life insurers – have the strategic luxury to decide what to do with those assets. Some insurers need the yield or have decided that paying taxes on capital gains now to receive a long-term stream of amortized benefits from the IMR isn’t worth it, which is why they don’t sell the appreciated assets (Lincoln and PacLife). Other companies would rather pay the taxes and get the money, even if it dribbles in over time (AIG and PennMutual). Deciding what to do with billions of dollars in gains you didn’t have to work for is not such a bad gig.

The trade, of course, also goes the other direction. In a consistently rising interest rate environment, bonds are devalued the moment they’re sold. Life insurers would be faced with a far more problematic choice – sell now at a loss to reinvest for higher yields or hang on to earn a yield that is no longer attractive. But here, life insurers face a new problem. If yields are falling, life insurers don’t have to work hard to provide better-than-market returns because their portfolio falls more slowly than the market. But if yields are rising, life insurers must pay a market rate or else policyholders will surrender their contracts (if they have the option) to transfer the money to a higher yielding instrument. Life insurers would be forced to sell devalued bond holdings rather than to hold to maturity, creating stores of realized capital losses rather than gains. There are some protections built for the life insurer such as the IMR, which amortizes the losses in the same way as the gains, and the ability for the insurer to delay surrender payments for 6 months. The insurer still has to pay the piper, but with a payment plan.

I say all this to make a simple point – we’re likely at a turning point in the life insurance industry where the risk to the life insurer from being an asset manager outweighs the rewards. It’s been a fantastic 35 years to be a life insurer asset manager and, arguably, the best decade was the most recent one. Life insurers could offer above-market rates and strategically tap huge stores of unrealized capital gains without a lot of skill. Now, yields are so low that managing money means one of two outcomes. Interest rates are either going to inch lower, which will provide the same benefits as over the past 30 years but with less room to drop, or they’re going to increase, which will put significant pressure on insurers as asset managers. The product guys will celebrate, the investment guys will sweat.

The solution is going to vary by company. Some firms are so heavily concentrated in long-tail guarantee products that the prospect of rising rates will be an almost unmitigated benefit because their clients aren’t being paid “market rates” and don’t have surrender values that can be weaponized against the insurer. For those firms, rising rates are akin to hitting your number in craps. It bails them out. They might even decide to double-down on the bet. And for many of these firms, they won’t have another choice. They’re all-in already. Their fate is sealed. 

The big mutual companies have a different choice. All four are practically flooded with capital. At Northwestern, for example, the company could pay an extraordinary dividend of nearly $5.7B – essentially 2019’s entire paid dividend – and the company would have roughly the same RBC ratio as Lincoln. New York Life could spare $3.7B to match Lincoln’s RBC, which is equal to roughly two years’ worth of dividends. The only mutual operating on an RBC ratio closer to Lincoln is MassMutual, but they have the distinct advantage of having the highest ratio of capital surplus to paid dividend (14.67), dwarfing Northwestern’s (5.57). A slight change in capitalization at MassMutual could provide a huge lift to the dividend. All of these firms have the ability to tap their prodigious capital stores to maintain market-level rates in a rising rate environment for long enough to have their investment yields rise. Whether they choose to do it is a different matter, but the opportunity is there.

For companies that have brought home the bacon for the last few years with Indexed UL, the headwinds are starting to pile up. Caps are obviously under immense pressure and the optics of the product have changed significantly over the last few years. Let’s not forget the fact that just 5 years ago, companies selling Indexed UL were telling their regulators that a 12% cap was “reasonable” and that it was “unrealistic” to think that caps would fall below 10%. Well, here we are, and there’s not really a solution. Falling rates will continue to put pressure on caps and illustrated rates. Rising interest rates will all but guarantee a swift decline in caps as option prices increase faster than portfolio rates. Over the past decade, there’s really not a good scenario for Indexed UL. It had its run. Companies made a lot of money. Now, the tide has turned. What’s a company to do?

Sell Variable UL, that’s what. Variable UL is the only product that doesn’t require a life insurer to be the asset manager. Life insurers had a good run as asset managers but now the times have changed. It’s time to hand over the keys. Who takes the bond duration risk in a Variable UL? The client. Who takes equity risk in a Variable UL? The client. And who reaps the rewards from taking the risk? The client. That’s the power of Variable UL. The client is the party to the transaction that is most able – and most willing – to take risk in order to earn commensurate return. It’s the best solution to a long-term low or rising rate environment for the life insurer.

But before we go, I want to make one other point that dawned on me as I was writing this. Most people think of Whole Life as the antithesis of Variable UL and, of course, that seems true. Whole Life is often positioned as the least risky, most stable, most consistent product on the market, a counterpoint to the wildly volatile and unpredictable Variable UL, with other forms of Universal Life lying in between. Framed that way, Whole Life and VUL have nothing in common. They are polar opposites.

I don’t think that’s the right way to view the products. A more accurate framework is to think of the dividend in Whole Life as an equity stake in the mutual company. If the mutual company takes a beating from selling devalued bonds in a rising rate environment, who pays for it? The client. If the bond fund in a Variable UL takes a beating from the same fact pattern, who pays for it? The client. Whole Life and Variable UL have far more in common than people think. You might even go so far as to say that Whole Life is a variable product invested entirely in the shares of a single company that provides the minimum guaranteed values for the policy. What makes Variable UL so incredibly resilient to any economic environment is that the client takes the risk. And, in a supreme twist of irony, that’s exactly what makes Whole Life resilient as well. If the future is about pushing more risk to the client, then it appears that both Whole Life and Variable UL have pieces of that future – albeit, very different ones.