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THE RISING TIDE - HOW LIFE INSURERS NAVIGATE INFLATION AND RISING INTEREST RATES

As a result of recent supply chain and labor market disruptions attributable at least in part to the pandemic, inflation has become a major concern for the first time in decades.  Lagging economic growth and the conflict between Russia and Ukraine have resulted in much higher energy and material costs, as well as increased market volatility. 

The primary tool the Federal Reserve uses to manage inflation is to increase the rate of interest charged on borrowed money. When it comes to interest rates and insurance, interest rate risk for insurance companies is a significant factor in determining profitability. Due to the protracted low interest rate environment, the insurance industry faced profitability challenges even before the pandemic, and the recent rise in inflation has added to them.  An insurer’s profitability typically rises and falls in concert as interest rates increase or decrease and impacts its operations in a number of areas, including the following:           

Life insurance products. Companies seeking to issue new life business in a rising interest rate environment may need to adjust their product design and business mix, as products that may have been profitable and competitive in a low interest rate environment may lose traction as rates increase.  For example, inflation, along with rising interest rates, are likely to make equity indexed life insurance and annuities less attractive to policyholders. On the other hand, as interest rates rise, insurers will be better able to offer insured products with more substantive interest rate guarantees. Life and annuity providers will face less pressure on the margins they earn from legacy blocks of annuity and insurance premiums with high minimum rate guarantees.

Transactions. Low interest rates have driven a significant portion of reinsurance and M & A activity over the past decade. The appetite for these transactions could decline as interest rates increase and more highly leveraged transactions come under pressure; higher interest rates and yields are making it more expensive to raise capital. 

Yet, the increase in Treasury yields also has created a shift in the investment environment to find ways to capitalize on rising rate scenarios. Unlike most sectors, life insurers are positively correlated to interest rate movement. Because insurers often reinvest policyholder premiums into the bond market, this allows them to profit when Treasury yields increase. As a result, one of the solutions private investors are looking at are life insurance companies as a source of permanent capital. In fact, this trend has seen a significant uptick in the past year.

Borrowing. The rising interest rate environment not only stresses financial performance, but also puts loan covenant compliance at risk.

As with many corporate borrowers, insurance companies are generally subject to financial covenants with triggers to enable the lender to monitor the borrower’s ongoing ability to repay the loan. A company experiencing financial challenges, such as declining revenue and cash balances, could be inadvertently violating a loan covenant providing the lender with remedies the company won’t want it to exercise. For insurance companies, Risk-Based Capital (RBC) thresholds are often included as a negative covenant. RBC measures the total capital of an insurer against certain benchmark thresholds of required capital, determined by a company’s-specific analysis. “Authorized Control Level” (ACL) is the absolute minimum amount of capital that an insurer must hold based on its risk profile. “Company Action Level” (CAL) is two times ACL. Certain remedies are available to the regulator if the insurer falls below CAL, with more drastic remedies if capital falls below ACL. 

In a best-case scenario, corporate or outside counsel may be able to negotiate on behalf of an insurer client a simple amendment of the loan agreement with new covenants based on projected financial information, a forbearance agreement, or exceptions to the restrictions in any negative covenants. 

Conducting a legal review of lending agreements will help to minimize the likelihood of tripping a covenant and may also allow a proactive restructure of the loan. This approach can also provide credibility with the lender during the negotiation process. A company’s legal counsel can play a crucial role in renegotiating these agreements and the risks should be discussed in concert with the company’s financial advisors and accountants. This includes a discussion on whether a violation of a covenant could potentially lead to the inclusion in the company’s audit opinion — a paragraph regarding the organization’s ability to continue as a going concern. That in itself could potentially be deemed a default event.

Reinsurance. As with most things in business, reinsurance is all about timing. While many insurers have utilized a robust reinsurance strategy during the low interest rate environment of the last several years, higher bond yields may drive interest back to pre-2008 methods investing and spreading of risk as opposed to an over-reliance on reinsurance. Complicated products will likely still see a heavy reliance on reinsurance, but the need for and activity in reinsurance markets may start to slow in a higher interest rate environment.

While reinsurers have been attractive to insurance companies based on the reinsurer ability to invest in alternative vehicles and more volatile investments, reinsurers have become savvy over the years. It would not be surprising to see reinsurers react to the new market realities, as well, and offer products that relate to a lower interest rate environment. Insurers would be well-served to review reinsurance contracts, explore options being offered by reinsurers, and determine the best mix of risk-spread for their business.

For reinsurers themselves, higher interest rates are seen as a positive to their bottom line, even though their assets have a longer duration and thus will take more time to realize the benefit.

CONCLUSION

The prolonged low interest rate environment has certainly had its challenges, but a rising interest rate environment coupled with inflation could present equally, if not more difficult, headwinds. Ironically, in recent history, insurers have become very good at taking advantage of low interest rate vehicles to raise capital. Now, in a new environment with higher rates and inflation to boot, they will have to be flexible and more creative to keep their balance sheets healthy.

Some action items for insurers to better prepare for continued rate hikes and inflation for the foreseeable future include:

  1. Performing an audit of product offerings and features and preparing analyses on the potential impact of the current environment. Prioritize actions based on this assessment.
  2. Reviewing and adjusting short and longer-term business strategy, including pricing strategy and capital requirements, to adapt to rising interest rates.
  3. Heightened expense management—particularly critical with longer-term elevated inflation despite higher interest rates.
  4. Reviewing loan engagements and other agreements, including reinsurance treaties, to determine if any action is needed—proactive or otherwise.
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