Issue: The recent low interest rate environment has had a notable impact on many segments of the economy, including the life insurance industry. Interest rates have declined significantly over the past several years in response to the 2007-2008 global financial crisis. An insurance CFO Survey conducted by Towers Watson in June 2012 (survey #30 ) showed almost all (97%) of the respondents consider interest rate risk a significant exposure for their company and almost half view the prolonged interest rate environment as their greatest threat to their business.

Overview: Between 2007 and 2014, the Federal Reserve (Fed) has used a variety of tools to stabilize the financial system, foster economic growth and keep interest rates low. It dramatically lowered the Fed Funds Target Rate to effectively zero where it has stayed since 2008. The Feds quantitative easing (QE) program, or large-scale purchases of long-term government bonds and other securities, in 2008, 2010 and 2012often called QE1, QE2 and QE3, pushed the benchmark 10-year Treasury yield down from fell from 4.7% at the start of 2007 to 1.9% at the end of 2011. Following the gradual phasing out of the bond-buying program by the Fed, the benchmark rate moved up to 3.03% at the end of 2013, before it slowly declined back to 2.17 % at the end of 2014.

The Fed ended 2014 with a pledge to be patient in raising interest rates from record lows. The Fed Chair has repeatedly placed the potential first rate increase sometime in the middle of 2015 but that would depend on the robustness of the economy. So long as inflation is under 2% and long-term inflation expectations are contained, rates are expected to remain low if needed, to help promote economic growth

The recent low interest rate environment has been a key concern for U.S. life insurers. Life insurance companies face considerable interest rate risk given their investments in fixed-income securities and their unique liabilities as their assets and liabilities are heavily exposed to interest rate movements. Interest rate risk can materialize in various ways, impacting life insurers earnings, capital and reserves, liquidity and competitiveness. Moreover, the impact of a low interest rate environment depends on the level and type of guarantees offered. Life insurers earnings are typically derived from the spread between their investment returns and what they credit as interest on insurance policies and products. During times of persistent low interest rates, life insurers income from investments might be insufficient to meet contractually guaranteed obligations to policyholders which cannot be lowered.

Persistent low interest rates can also affect earnings and life insurers liquidity. Liquidity management is critical for life insurers. As part of asset-liability management (ALM), life companies strive to match liability cash flows with asset cash flows to avoid setting up an additional asset-liability mismatch reserve. During periods of low interest rates, assets and liabilities cash flows can be seriously mismatched, exposing insurers to losses from uneconomic asset sales to meet current obligations to policyholders. While under conditions of persistent low interest rates, life insurers earnings are squeezed, 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 scant availability of higher-yielding alternatives.

Insurers have various tools to address the risk of persistently low interest rates. Increasing the duration of their assets to ensure better matching between assets and liabilities is at the core of life companies interest rate risk strategies as part of their overall ALM. Insurers also can lower the terms of new policies (e.g. by lowering guaranteed rates), thereby progressively lowering liabilities. 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 .

Rising interest rates should improve life insurers cash flows, relieving some of the pressure related to reserving. In addition, investment income trends may become more promising, helping insurers recover their capital position.

Status: The NAIC has been actively monitoring the low interest rate environment. An NAIC study of the impact of the low interest rate environment on life insurers was recently conducted covering the 2006-2013 calendar year period. The data used was sourced from the annual statements of 713 life insurance company legal entities whose reserves represented 99% of the total industry life insurance reserves during that period. The study showed a squeeze in the spread between the net investment portfolio yield and the guaranteed interest rate during that period, particularly from 2008 to 2009namely, at the peak years of the global financial crisis. Total industry reserves grew from $1.98 trillion in 2006 to $2.88 trillion by the end of 2013 as a result of the low interest rates during that period.

The study found that while the recent period of the low interest environment created spread compression on earnings, it did not materially impact life insurers solvency. To manage their interest rate risk, life insurers are matching their asset and liability cash flows. 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 interest rate scenarios (typically 1,000+ scenarios), as well as a set of seven deterministic interest rate scenarios prescribed by state insurance regulators.

Such interest rate scenarios provide a good set of stress tests to help ensure life insurance companies have either well-matched asset and liability cash flows 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 an additional reserve if the appointed actuary determines a significant amount of mismatch exists between the companys asset and liability cash flows. As part of this study, the NAIC pulled the additional reserves liabilities established by companies at year-end 2012. The life insurance industry posted an additional asset/liability cash flow risk reserve of $9.7 billion. Additional information from the study can be found in the January 2014 CIPR Newsletter article Life Insurers to Benefit from Rising Interest Rates . Moreover, the CIPR is currently examining interest rate risk, particularly the liquidity and disintermediation risk faced by life insurers, and plans to release the results/analysis in a study later this year.