The interest rate environment experienced over the past several years impacted various segments of the economy, including the life insurance industry. A period of such prolonged low interest rates is unprecedented and has made it increasingly important for life insurers to understand how interest rates can affect firm value. This article will discuss the effects of interest rate risk on the valuation of life insurance companies and options available to them to manage this risk. Additionally, it will address the impact of the current and expected interest rate environment on life insurance company valuations.
Below is a simple formula that can be used as a framework for considering the relevant issues in analyzing the relationship between interest rates and a firm's equity value:
Equity Value = Asset Value – Liability Value
A life insurance company's assets are primarily financial in nature and are composed of bonds and stocks.1 The company's liabilities consist of expected payments owed on policies sold to various individuals. Life insurers collect premiums from policy owners, which they invest in stocks and bonds. They aim to generate returns in excess of their liabilities through investment income and capital gains.2 This income is then shared with policy holders through annuities or the policy's cash value.
Equity value is the residual claim of the owners in the assets of the company after deduction of the company's liabilities.3 Generally, the value of a company's equity is driven by its growth prospects, risk profile, and expected profitability. All else equal, companies with higher growth, greater profitability, and lower risk will generally have higher valuations.
One metric that captures these elements and is utilized by insurance industry analysts to assess equity valuations is the price-to-earnings (P/E) multiple. The P/E multiple represents the value of a firm's equity per dollar of earnings and can be based on historical earnings, such as net income during the latest 12 months, or forward earnings, such as net income expected in the next 12 months. By analyzing trends in valuation multiples, analysts can gain a better understanding of the market's assessment of a company's growth prospects and risk profile, both of which could be impacted by the interest rate environment.
Effects of Interest Rate Risk on Life Insurance Company Valuations
Earnings spread compression is a major risk for life insurance companies. Life insurers generate income by producing portfolio returns in excess of what they owe on policies.4 Two-thirds of investment income is related to fixed income securities, the prices and returns of which are highly dependent on interest rates.5 Reduced coupon rates associated with low interest rates generally inhibit investment income. Additionally, insurers are forced to reinvest their earnings at a lower rate, exacerbating the earnings spread compression. Persistent low rates, like those experienced in the past several years, may hinder investments from generating enough income to meet obligations to policyholders.
Alternatively, an increasing interest rate environment creates disintermediation risk. Disintermediation risk refers to the potential that policyholders may surrender policies due to rising interest rates.6 Sharp rises in interest rates heighten this risk by offering policyholders the opportunity for greater returns if they withdraw funds from their policy and invest elsewhere. In times of interest rate spikes, insurers may be forced to increase crediting rates to keep business, which reduces their spread and, consequently, their earnings.7
Trends in Valuation Multiples
To better understand how changing interest rates affect life insurance company values, we looked at the following companies (the "Life Insurance Industry Group") to represent the life insurance industry:
AFLAC, Inc. (AFL)
CNO Financial Group, Inc. (CNO)
Kansas City Life Insurance Company (KCLI)
Lincoln National Corporation (LNC)
Manulife Financial Corporation (MFC)
MetLife, Inc. (MET)
National Western Life Insurance Company (NWLI)
Principal Financial Group (PFG)
Protective Life Corporation (PL)
Prudential Financial, Inc. (PRU)
Sun Life Financial, Inc. (SLF)
Symetra Financial Corporation (SYA)
The Phoenix Companies, Inc. (PNX)
Torchmark Corporation (TMK)
The following graph compares P/E multiples to interest rates and suggests that during periods of prolonged low interest rates, there is more perceived risk for life insurance companies, as evidenced by lower P/E multiples. Slight increases in interest rates seem to promote confidence in the financial stability and value of these companies, as reflected in the higher P/E multiples.
Figure 1: Life Insurance Industry Group P/E Multiples versus Risk-Free Rates
While still below historical levels, interest rates have been rising in the past few months, allowing fixed rate annuities and similar products to perform better. Despite the low interest rate environment, life insurers have performed well in 2013. Companies in the industry have strong risk-adjusted capital positions, higher earnings, and improved balance sheet fundamentals achieved through enhanced risk management and de-risking initiatives.8 As such, investors are optimistic about insurance companies, as is reflected by increased P/E multiples.
Managing Interest Rate Risk
Because interest rate volatility can pose a threat to life insurance companies, it is important for insurers to immunize themselves against interest rate risk. One strategy for achieving this is duration matching. Duration can be thought of as "the number of years required to recover the true cost of a bond, considering the present value of all coupon and principal payments received."9 While duration matching is very effective at reducing risk, it can be difficult in practice. Often, the duration of liabilities is greater than the duration of assets available for purchase.10
Risk can also be reduced by diversification of products and investments. Insurers can balance interest-sensitive offerings with non-interest-sensitive products. Additionally, they can diversify their investments. In recent years, with unusually low rates on treasuries, the industry's largest source of income has been from high-grade corporate bonds.11 Insurers can also mitigate risk by investing in derivatives like fixed-income futures and interest rate floors, swaps, and swaptions.
Although insurers do take measures to manage investment rate risk, the extent to which they can is limited, particularly in a situation of prolonged low interest rates. Crediting rates have guaranteed minimums, meaning insurers must pay out certain amounts to policyholders. Additionally, the persistence of low interest rates will force insurers to reinvest at lower rates, intensifying the earnings compression associated with low interest rates.12
Changes in interest rates can pose a significant challenge to insurers, so understanding the impact of rate changes is important. Much of the business on the insurers' books tends to perform poorly in very high or very low interest rate environments.
Interest rates have experienced greater volatility during the past several months. Although the Federal Reserve announced in July that it expects to keep interest rates low for a significant period of time, rates have been steadily increasing.13 A continued rise in interest rates would be credit positive for life insurers, as spread products would regain popularity and reinvestment would decline. However, a rapid spike in interest rates could lead to annuity policyholders moving to higher-return products at the same time that life insurers' investment portfolios report unrealized losses.14 Since it appears that interest rate volatility may continue in the near-term, it is key for insurers to develop risk management programs to maintain value and allow for long-term growth.15 The ideal situation for most life insurers would be for rates to gradually return to "normal" levels.16 This would allow insurers to regain their earnings spread with minimal disintermediation risk.
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1 Doug Kelly, "Way of life: unemployment will remain high, but a risk in investment income will boost revenue," IBISWorld Industry Report 52411a Life Insurance & Annuities in the US, IBISWorld (Mar. 2013).
2 Elijah Brewer III, James M. Carson, Elyas Elyasiani, Iqbal Mansur, and William L. Scott, "Interest Rate Risk and Equity Values of Life Insurance Companies: A Garch-M Model," The Journal of Risk and Insurance 74.2 (2007): 403.
3 Statement of Financial Accounting Concepts No. 6, "Elements of Financial Statements," FASB, 1980.
4 Larry Bruning, Shanique Hall, and Dimitris Karapiperis, "Low Interest Rates and the Implications on Life Insurers," The Center for Insurance Policy and Research Newsletter (April 2012): 2.
5 Doug Kelly, "Way of life: unemployment will remain high, but a risk in investment income will boost revenue," IBISWorld Industry Report 52311a Life Insurance & Annuities in the US, IBISWorld (March 2013).