#296 | The Unstoppable Force and the Immovable Object

green and white tidal waves

Over the past decade, the entire life insurance industry has been reshaped by falling and then persistently low interest rates and investment yields. Life insurers have exited the market, been sold, spun off and now, increasingly, parceled up and dumped onto weaker and less experienced third party firms. Products with long-duration guarantees have all but dried up. Crediting rates on Universal Life and caps on Indexed UL have taken a beating. The current interest rate environment is an unstoppable force.

But it seems to have also met an immovable object – Whole Life dividend interest rates. The traditional intuition is that falling interest rates directly impact dividend interest rates. For the past 30 years or so, that’s been true, but recently the connection has broken down. Investment yields are lower than ever, but four life insurance companies just announced that they’re holding their dividend interest rate for 2022 – New York Life, Northwestern Mutual, MassMutual and Penn Mutual. This isn’t an aberration. Three of those four companies also held dividends last year. It seems as though dividend interest rates are an immovable object.

What happens when an unstoppable force meets an immovable object? The first time I remember hearing that paradox was in The Dark Knight. The scene is fantastic. It’s the soul of the film. The Joker is plummeting to his death after seeing his plans ruined by the good will of men and Batman catches him by the ankle with a grapple hook, hoisting him back up. Hanging upside down, the Joker chuckles and says “this is what happens when an unstoppable force meets an immovable object. You, truly are, incorruptible, aren’t you? You won’t kill me out of some misplaced sense of self-righteousness. And I won’t kill you because you’re just too much fun. I think you and I are destined to do this forever.”

Implicit in the paradox is that the unstoppable force is actually unstoppable and that the immovable object is actually immovable. In the case of Whole Life, neither is true, despite how things may feel. I wrote two years ago in #194 | 2020 Whole Life Dividend Rate Recapabout how mutual life insurers are beginning to invest in other, non-participating business lines. In a low interest rate environment, earnings from these other business lines have an outsized and leveraged effect on the overall earnings available to participating policyholders relative to traditional line items like net investment income. MassMutual specifically called earnings from other businesses as a reason for its ability to maintain its dividend interest rate in its 2022 dividend announcement, stating that “an important differentiator…continues to be earnings from non-participating insurance businesses…as well as ownership interests in global asset management and other strategic investments.”

However, I think there’s more to the story for 2021 than just outside business earnings. Northwestern Mutual has virtually no outside business earnings because all of its business lines are participating, and yet Northwestern Mutual also held dividends. The same goes for New York Life. There has to be something else going on.

Let’s take a step back and think about one of the key tensions at mutual life insurance company – capital versus dividend. Those are the only two places that statutory profits can go at a mutual company. Any dividend is paid at the expense of augmenting corporate capital. What’s less commonly considered, though, is that the relationship goes the other way as well. Take a look at the ratio of corporate capital to paid dividends using 2020 statutory financial data:

Northwestern MutualNew York LifeMassMutualGuardianPenn Mutual
EOY 2020 Surplus24,957,453,11821,728,391,31524,327,413,3357,759,742,0012,261,030,746
Control Level RBC (x2)7,201,192,4726,029,462,1685,982,989,3581,843,261,544538,707,512
Excess Capital Surplus17,756,260,64615,698,929,14718,344,423,9775,916,480,4571,722,323,234
2020 Dividend6,234,878,6871,962,873,0151,697,380,6411,035,927,853108,653,841
Ratio285%800%1081%571%1585%

What this means, theoretically, is that New York Life (for example) could pay a dividend that is eight times the size of its actual 2020 dividend before it bumps into a regulatory RBC guardrail. This would, of course, be highly inadvisable. New York Life would have to submit a rehabilitation plan to its regulator and its ratings would tank, probably putting it somewhere in the C range for AM Best. Think of capital as a huge store of “potential dividends” sitting on its balance sheet that, instead, are being used to bolster credit ratings and protect the insurer from potential investment (or product) losses.

Thinking about capital from that vantage point leads to another interesting angle – if capital is growing regardless of the actual profit and loss of the business, then it’s possible that the life insurer can support dividends that would otherwise not be supportable. Why would capital just grow? The statutory filings give us something of a clue. I’ll be the first one to admit that statutory filings can be difficult to decipher, particularly the truncated statements released for quarterly financials. But, even so, there’s a clear trend happening this year that wasn’t happening last year in a usually-unnoticed line item that feeds directly into capital – unrealized capital gains.

Unrealized capital gains are a bit of an odd-ball financial line item. When most people hear that term, my guess is that they’re thinking of something like the increase in the value of a bond held on the life insurer’s balance sheet as a result of falling interest rates, but that’s not actually what it is. Bonds are always held at book value. You can find the difference between the market valuation of the bonds and the book valuation of the bonds buried in Schedule D. In the case of Northwestern Mutual for 2020, if the unrealized capital gains in the bond book were added to statutory surplus, they would tack on an extra $17 billion, growing the total surplus by nearly 70%. Life insurers financials would essentially hinge on bond valuations. That would not be a good thing given that the vast majority of those bonds are held to maturity and only marked-to-market if they’re actually liquidated or there has been a significant credit event in the bond itself. All of that to say, bonds aren’t the source of unrealized gains on a life insurer’s balance sheet.

If not bonds, then what? In the Notes to the Statutory Filing, unrealized gains are defined this way – “unrealized capital gains and losses include changes in the fair value of common and some preferred stocks, other investments and…changes in the company’s equity method share of the accumulated earnings of joint ventures, partnerships and unconsolidated non-insurance subsidiaries are also reported as changes in unrealized net capital gains and losses.” So, in short, everything else. It’s also important to note that changes to the valuation of insurance related subsidiaries (equal to the surplus at the entity) also show up in unrealized capital gains and losses because those entities are held by affiliated common stock.

You may be wondering at this point why I’m going into all of this minutiae about unrealized capital gains. I made the point at the beginning of this article that the general received wisdom is that dividends drop with interest rates, but it seems as though that connection has been severed of late. An unstoppable force has met an immovable object. How is that possible? I think there are a lot of explanations, including outside business earnings, but unrealized capital gains is certainly one of them.

The Q3 financials (Q2 for Guardian) shed a bit of insight into what may be going on. Take a look at  the change in the unrealized capital gains positions of the Big 4 mutuals:

Northwestern MutualNew York LifeMassMutualGuardian
Q3 2021 Unrealized Gain Change2,263,850,1381,625,191,0633,374,556,720358,336,125
Q3 2021 Net Income255,980705,364,442-1,117,685,001161,040,787
Q3 2021 Surplus28,143,356,23123,692,458,85425,820,413,7158,147,221,271
YoY Surplus Increase3,185,903,1131,964,067,5391,493,000,380387,479,270
Surplus Increase as % of 2020 Dividend51%100%88%37%

MassMutual is particularly instructive. Despite the fact that MassMutual lost $1.1B on a statutory basis in its actual business lines – which, based on past Q3 filings, seems like a fairly common occurrence before Mass turns it around for year-end accounting – the loss was more than made up for through an increase in unrealized capital gains. $1.4B of that came from Schedule BA (other long-term invested) assets and another $1B came from Schedule D (bonds and stocks) assets. Another $1.7B came from Schedule DB (derivatives). Guardian’s unrealized gains came almost exclusively from Schedule BA. New York Life and Northwestern didn’t provide the breakout in their quarterly filings, but it’s highly likely that their gains came from the same places, particularly Northwestern, which has traditionally held more common equities than its peers (and gains in those equities generated almost all of its unrealized capital gains for YE 2020).

The story of these unrealized capital gains is exactly what we’ve seen in 2021 – a massive, universal and unrelenting inflation of valuations across all classes of equity-based investments. Mutual companies are beneficiaries of that and, by extension, so are their policyholders. To the credit of the mutuals, none of them dramatically augmented their dividend to reflect their asset returns, but it’s entirely possible that the life insurers viewed this strange economic environment of ultra-low rates and gangbuster asset returns as an opportunity to hold the line on dividends when they might not have otherwise.

Based on a quick (and probably incomplete) view of total surplus, it appears that unrealized capital gains have become a major part of overall surplus over the past decade. From 2014 to 2021, for example, New York Life’s surplus has grown from $18.6B to $23.7B. The change in the unrealized capital gains are recorded each year in the filings, so if you add them all up, you can get a rough estimate of the total pool of unrealized capital gains in the surplus. For NYL, total reported unrealized capital gains have grown from $1.06B in 2014 to $5.3B in 2020. In percentage terms, unrealized capital gains made up 5.71% of surplus in 2014 and now make up 22.4%. Take a look at the two figures over time:

New York Life

If that sounds like a lot, then consider MassMutual. In 2011, the first year of financials available on the website, unrealized capital gains made up 12.5% of total surplus. Now, it’s just north of 60%. Take a look at the trend over time:

MassMutual

This got me kind of curious, so I dug into my files to see if I had any statutory filings for any particular company on hand dating back to 2008. The only one I had a complete history for was Securian, so take a look at theirs:

Securian (Minnesota Life)

For most of Securian’s history, unrealized capital gains were essentially a net zero line item contributing (on average) just 1.6% of surplus. By Q3 2021, however, unrealized capital gains made up 15.8% of surplus. I had history for Penn Mutual going back to 2010 and the results looked a bit like Securian. On average, unrealized capital gains were actually a drag on surplus to the tune of 3.5%. But that started to turn around in 2018 and now unrealized capital gains make up 9% of total surplus.

Based on the data in the statutory filings, it appears as though unrealized capital gains are much of the fuel that has led capitalization of life insurers to all-time highs over the last few years. My gut is that this runs counter to the narrative of life insurer capital that is prevalent in our industry. When people think about life insurer capital, they imagine a vault full of cold, hard cash ready to be deployed to keep the company afloat while the rest of the world burns. As I’ve written numerous times in the past, financial engineering structures such as captives – which are extremely prevalent in all but the Big 4 mutuals and a few others – have undermined the idea of actually holding real capital against liabilities by allowing life insurers to use “soft” capital.

But in the case of unrealized capital gains, the culprit isn’t financial engineering. It’s just statutory accounting. Bonds are held at book value – not so for equity positions. As a result, life insurers have had their balance sheets inflated with unrealized capital gains that appear to be coming from overall inflated values of risk-on assets. The mental image that comes to mind is the scene in Dumb and Dumber – “Listen, Mr. Samsonite, that’s as good as money, sir. Those are IOUs. Go ahead and add it up. Every cent’s accounted for.” That’s obviously hyperbolic, but the point stands – if you were to crack open the capital briefcase of many major life insurers, you’d find a whole lot of cash and a whole lot of other stuff, too.

So far, those unrealized capital gains have been a blockbuster source of capital augmentation. But not all unrealized gains are the same. Some are stickier than others. Derivatives, by their nature, are transitory and speculative. Public equities have long-term trends but huge short-term variations. Alternative asset classes can be stable but with Black Swan-type events. Privately owned companies – as in, non-insurance operations owned by the mutual company – can be huge sources of sustainable long-term profits independent of external economic cycles, depending on the business. To bring it back to the Dumb and Dumber analogy, if there are IOUs in the briefcase, then it really matters who’s name is on the IOU. And I highly doubt that any life insurance companies have taken IOUs from the equivalent of Harry and Lloyd, proprietors of the mobile dog grooming service operated out of the back of a van that looks like a dog.

The future, however, may not look like the past. What happens if rates rise and equities fall? Life insurers could see their massive stores of fair market bond gains evaporate along with actual statutory unrealized capital gains, at least for their equity-based positions. It will take a long time for portfolio yields to start to show the effect of rising rates. It is entirely possible – as bizarre as this sounds – that dividends could fall in the immediate aftermath of a rising rate, falling equity environment because of the dynamics playing out in the surplus account with unrealized capital gains.

This brings us back to the original paradox – has an unstoppable force met an immovable object? No. The force is unstoppable, but the object is not immovable. It just looks that way for now. How the objects move, however, will depend on a variety of factors that aren’t necessarily predictable or immediately obvious. What do you do in the face of uncertainty? Dig deep. Be an equity analyst. Know the company you’re selling and get comfortable with its story of how it’s facing the future on behalf of your clients. At the end of the day, a Whole Life policy is simply an equity stake in the company that sells it. Full stop. End of story. Act accordingly.