When notes from the September 2023 Federal Open Market Committee meeting were released last month, they revealed that some members thought further interest rate increases might be appropriate. This led many financial market commentators to conclude that interest rates will remain higher for longer. If that is the case, how will it affect the balance sheets of insurance companies and the payments they make on the annuities they have issued?
Investments on Insurance Company Balance Sheets
The National Association of Insurance Commissioners (NAIC) Capital Markets Bureau has been tracking insurance company investments since 2010. They report that insurance companies are traditionally conservative investors.
According to the NAIC, most assets that insurance companies hold are fixed income securities, such as bonds and mortgages.
At the end of 2022, bonds made up over 62% of the investments held by U.S. insurers. An additional 9% of the investments were mortgage-backed securities.
Interest Rate Increases and Bond Prices
In response to inflation, the Federal Reserve began raising short-term interest rates in March 2022. Since then, there have been 11 increases in the Federal Funds rate.
Today, the Federal Funds rate exceeds 5.3%, a significant climb from the initial 0.3%. These adjustments have notable implications for fixed income securities, whose returns guarantee the income an annuity generates.
According to Mike Prager, Chief Actuary & Risk Officer at Great American Insurance Group’s Annuities division, the majority “of the investment yield generated by an insurer’s bonds is credited to” annuity contract owners.
As interest rates climb, bond prices tend to experience a decline. Since March 2022, the yield on the 10-year U.S. Treasury bond has more than doubled, leading to an over 8.3% decrease in the S&P 500 Bond Index.
The inverse relationship between interest rates and bond process has a direct impact on an insurance company’s balance sheet and its ability to make payments on annuity contracts.
Bonds on an Insurer’s Balance Sheet Pose Risks to Annuitants
Bonds held on an insurer’s balance sheet pose risks to annuity holders because they can affect the insurer’s reserves. Reserves are what the insurer needs to meet its contractual obligations, like annuity payments.
Insurance companies have flexibility in reporting bond values. Their choice affects whether declines in bond values are reported as losses or amortized as part of their cost. The choice an insurance company makes affects its reserves.
Therefore, declines in bond values could push an insurer’s reserves below the threshold necessary to pay annuitants.
How Big of a Risk Do Bonds Pose to Annuity Holders?
Interest rate increases negatively affect bonds held by insurance companies. Yet, according to the Insurance Information Institute, changes in bond values may not necessarily impact an insurer’s balance sheet.
Although higher rates lead to lower bond prices, there’s a silver lining: insurance companies can reinvest the proceeds from maturing bonds into higher-yield instruments.
This is advantageous to consumers, so increasing interest rates shouldn’t be a cause for worry for annuity buyers. Higher rates offer insurance companies more cushion around annuity payments. This should be comforting to consumers concerned about the economy or the financial condition of the insurance company that issued their annuity.