August 29th, 2013
by Kyal Berends, Robert McMenamin, Thanases Plestis, and Richard J. Rosen - Economic Perspectives, Federal Reserve Bank of Chicago
A Chicago Fed study finds that when bonds increase in value (that is, when interest rates fall), stocks of large insurance firms decrease in value more than those of their smaller counterparts.
The study concludes:
Interest rates in the United States fell sharply at the onset of the financial crisis in late 2007, and the United States is currently in an extended period of low interest rates. While low interest rates are seen to benefit the economy by facilitating investment and borrowing, a prolonged period of low interest rates poses challenges for certain sectors of the economy, such as life insurance. Life insurers, as part of their core lines of business, acquire interest-rate-sensitive liabilities and assets, many of which have embedded options whose value depends on interest rates. To gain a better understanding of the impact of prolonged low interest rates on life insurance companies, we study to what degree life insurers were exposed to interest rate risk in both the pre-crisis period and current low-rate period.
Specifically, we study publicly traded life insurance firms during the period August 2002 through December 2012. Before the financial crisis, large life insurers’ stock returns were essentially uncorrelated with ten-year Treasury bond returns. After the crisis (that is, in the recent low-rate period), the stock returns of large life insurers were negatively correlated with the returns on ten-year Treasury bonds. We find that the average level of large life insurers’ stock returns is lower now than in the pre-crisis period, and these returns are more sensitive to changes in interest rates. These findings are consistent with two observations. First, the rapid decline in interest rates during the financial crisis and Great Recession left many of the guarantees in insurance products in the money and were associated with policyholders being less likely to withdraw the cash value of their policies. This finding has led life insurers’ share prices to react more to changes in interest rates. Note that the stock returns for small life insurers react less to changes in bond returns than those of large insurers. Second, some insurance products such as fixedrate annuities are not very attractive to customers when interest rates are low.
We compare life insurance firms to banks and property and casualty insurance firms. During the pre-crisis period, stock returns for banks and PC insurers moved very little with interest rate changes. In the low-rate period, this was still true for PC insurers and small banks. However, during the low-rate period, the exposure to interest rate risk of large banks was roughly similar in magnitude to that of large life insurance firms.
Life insurance firms play a large role in the U.S. economy. This study confirms that changes in interest rates are important to these firms. It also shows that the recent period of low interest rates has made it more challenging for life insurers to manage their assets and liabilities.
The full study follows:
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