The interest rate picture continues to dominate the credit outlook for the insurance sector, as firms look forward to rising rates in the U.S., and continue to grapple with rock bottom rates in Europe in the meantime.
In a new report Moody’s Investors Service says that rising rates would be credit positive for the U.S. life insurance sector, “as spread products would regain popularity and reinvestment risk would decline.”
The rating agency suggests that higher rates would increase the appetite for spread-based products, such as fixed rate annuities, which fell out of favour with consumers and insurers given low rates and tight credit spreads. Prior to the financial crisis and the onset of historically low rates, annuities had been an industry growth engine for about 20 years, it notes.
Additionally, Moody’s says that rising rates would reduce reinvestment risk for companies as both new money rates and portfolio yields would rise. Products that would benefit from higher rates include structured settlements, pension products, universal and interest-sensitive life, long-term care and long-term disability products, it notes.
“We could revise our U.S. life insurance sector outlook to stable from our current negative stance if the recent rising interest rate trend and improving economy continues,” said Neil Strauss, vice president and senior credit officer for Moody’s. “The prolonged low interest rate environment and macroeconomic challenges are major contributors to our negative sector outlook.”
However, it also warns that a steep, rapid increase in rates would be negative for most life insurers. “In this scenario, annuity policyholders may flock to new products with higher returns, including bank products which react more quickly to a rise in new money rates,” says the rating agency. “At the same time, the market value of insurers’ fixed income holdings would decrease due to the rise in rates, leading to unrealized capital losses.”
Meanwhile, for European insurers, Moody’s says that low rates, along with new regulations, are beginning to drive firms to diversify their asset allocation by investing in new, more illiquid, asset classes, notably private loans. And, Moody’s says that it believes that the trend towards greater diversification will accelerate in the coming years, as firms chase yields in a low rate environment, and look to reduce concentration risk. Additionally, tougher capital rules for banks are creating new investment opportunities for insurers, it notes.
While it expects that there will be only minor changes to insurers’ investment portfolios in the next 12-18 months, Moody’s says that if the low interest rate environment continues, and investment opportunities arise, more material shifts in insurers’ portfolios will occur. In the long-term, the rating agency expects that insurers will increase their exposure to real estate and loans at the expense of public corporate bonds and covered bonds.
Moody’s anticipates that these changes will have negative credit implications for insurance companies for two main reasons: the weight of illiquid investments is likely to increase substantially; and, some insurers have limited expertise in some of these asset classes, which still lack a consistent legal and contractual framework in some cases, thereby carrying particular risks for investors.