How do Low Interest Rates Affect Life Insurance Policies?

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The interest rate is a policy tool which is used by the central banking institution to fulfil its own mandates in the market. For instance, the Central Bank of the UAE controls the banking infrastructure of the country through its policy directives. This is done while keeping in mind the employment rate in the country, as well as the inflation situation. Interest rate is primarily used to affect the borrowing rate of the commercial banks, and this either squeezes or multiplies the supply of money in the economy. The prevailing interest rate can have multifarious effects on the economy. Lowering of interest rate makes it easier to borrow money in the economy from commercial banks or allied financial institutions. This will naturally lead to greater willingness among businesses or households to spend. On the other hand, an increase in interest rate is aimed at contracting the money supply, and it will have repercussions on the economy in a similar vein. 

Interest Rate Risk

The life insurance industry has traditionally been vulnerable to changes in the long-term interest rate policy. The ongoing interest rate is considered by the top companies in determining the premiums that the company pays out, the amount to be held in policy reserve, and the rate of return that it is able to guarantee. Consistently low interest rates can be a problem for companies dealing in life insurance, given the fact that their products are rate sensitive. Lower interest rates can be an issue for the portfolio that a company holds, as they have interest-sensitive investments, such as bonds whose value they need to manage. In addition, the demand for their products are also likely to be affected by interest linked factors such as money supply, liquidity in the economy etc. 

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Impact on Regular Life Insurers in the Industry

The struggle before an economist or a policy bureaucrat is to try and predict where the interest rates might end up in a month or two. They do this in order to leverage their knowledge with central banks or financial institutions. However, the same challenge is much more substantial in front of a life insurance company. A company providing life insurance typically has to take calls on what the future holds for interest rates. Based on that it has to take calls regarding the payouts on premium that it is offering, the investments of the revenue that it chooses to make etc. The company needs to try and have that kind of foresight in the market, because the very instruments that it deals with are long-term in that sense. The liabilities that the company may hold, such as premiums payable to prospects and clients, say, over the next 40 runs, may outrun the maximum duration of investments in the capital market. But given the circumstantial nature of the economy, there are bound to be variations in the estimates and differences from the expectations. The company needs to set aside reserves to face these challenges. How does one handle such decisions? The components of the decision to be taken are: what level to keep the premiums at, the rate of return that should be guaranteed, and how much money should be kept within the policy reserves. This would obviously imply making assumptions about the future of the capital market, which in itself, is a process that is in no way certain.  

Impact of Rate Change on Assets

How does a life insurance company primarily make money? The key is to look at the returns that they make out of their investments, minus the credit they offer on consumer products. It is a well-known fact that life insurance companies are usually the largest investors in corporate bonds. Asset-liability management studies show that insurance companies tend to invest on excess yields from corporate bonds during periods of low interest, and the cited reason for this is to get the benefits of increased duration as compared to credit risk. The most direct way in which the financial position of the insurance company is bound to be affected, is through a movement in the prices of the long-term stocks and bonds that the company has invested in. As the interest rates constantly fluctuate, the profitability of an insurance company also varies. The index that needs to be referred to, is known as the Combined ratio. This is in contrast to the expense ratio and the loss ratio, which are used to keep track of the administrative costs of the company’s financial process. The combined ratio seeks to divide the outflows of the company (losses, claims processed etc) by the sum total of the revenue that it is able to generate. This ratio then gives a picture of the company’s financial performance, as it is difficult to keep track of the general profitability of the company. Thus, one way to determine whether the company has made the most of the current situation in the market can be to correlate the movements in the combined ratio to the movements in the interest rate. Also, different insurance companies are differently susceptible to changes in the interest rate; it depends on the line of insurance products that they are dealing in, the distribution of the products, and also the portfolio of investments that the company manages. For example, a company providing life insurance is more likely to be affected by changes in interest rate than say a company giving motor insurance, or travel insurance. This is due to the need to manage the payable products of full-scale life insurance, annuities, while maintaining a profitable combined ratio.  

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Impact of Rate Change on Liabilities

Apart from the investment portfolio side, a change in interest rate is also bound to affect the liabilities that the company holds, i.e. the premium that it has to pay to its policyholders. For instance, a decrease in interest rate would tend to decrease the volume of outstanding liabilities that a company owes to its policyholders. Conversely, the lowering interest rate could play out in other interesting ways as well. For instance, it could imply greater monetary liquidity in the hands of the people, thus driving greater sales on their part. On a different level, low interest rates can hamper the liquidity of the life insurance company. Liquidity refers to the ease with which a company may avail of its assets, and convert it into its monetary value. During times of low interest rates, due to the decline in cash availability, companies may struggle to maintain their liabilities versus the assets they hold.

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