NEW YORK (Reuters) - The Federal Reserve’s latest move to stimulate credit for consumers and businesses, known as Operation Twist, is likely to threaten the earnings of some of the country’s largest insurers for years to come.
Wall Street in the past week has dimmed its view of MetLife, Prudential Financial and other big insurers, forecasting that they will have to cope with low rates and weak market returns through the end of 2011 and possibly well beyond.
The problem is that returns on insurers’ investment portfolios can’t keep pace with the obligations they have accumulated from torrid sales of annuities and life policies over the past few years.
“Ultimately I think it’s going to be a challenge to business models,” said Gregory Staples, co-head of U.S. fixed income portfolio management at Deutsche Insurance Asset Management, the world’s largest asset manager for insurers.
Insurers were demonstrating sound financial management in purchasing long-term bonds with the premiums they collected to balance their long-term obligations. But if the Fed’s Operation Twist is successfully executed it will push long-term rates lower and, according to some experts, force insurers to retrench on product sales.
No one is suggesting Twist will put insurers out of business, but it is exacerbating a problem that they have been contending with since the financial crisis of 2008.
Under Operation Twist, as announced Wednesday, the Federal Reserve sell shorter-term notes to buy longer-dates Treasuries. That will have the effect of keeping longer-term interest rates down, which the Fed hopes will spur consumers to borrow and spend.
“Folks have brought the low interest-rate environment up to No. 1 priority,” said Doug French, managing principal of the insurance and actuarial advisory practice at Ernst & Young. “We’re not going to get any relief from interest rates for the next two to three years.”
The accounting firm has modeled the investment return needs of the 25 largest life insurers over the next three years to determine what will happen if rates remain static or fall further.
”Their general account yields (in aggregate) are going to decrease by about 51 basis points over the next three years, and that’s a cumulative effect,“ French said. ”The life industry is under spread compression. It’s just going to continue, and, in fact, it’s going to get worse.
Annuities, a little understood but increasingly popular alternative for older Americans, are a paradoxical problem for insurers when rates plummet.
Limra, a marketing and research group for life insurers, estimates that 35 percent of U.S. retirees receive income from annuities. MetLife, the largest life insurer in the United States, reported that annuity sales rose 48 percent in this year’s second quarter.
Many of the products are sold with a guaranteed minimum benefit in return for an upfront payment. That means that regardless of the strength or weakness of the markets, the insurer has to write a check that doesn’t vary throughout the life of the product.
And that life is getting longer. Several insurers late last year warned that people were holding on to their annuities rather than cashing them out to invest in higher-return products. That creates a bigger nut for the insurers at a time when markets and the central bank aren’t cooperating.
“Once you get a little further out, there’s a very strong consensus that interest rates need to rise,” said JMP Securities analyst Matt Carletti. He and others said insurers are resigning themselves to anemic rates of return.
“Everybody expects a rise in interest rates but few expect it to happen any time soon,” Carletti said.
Rates on 10-year U.S. Treasuries prior to the Fed’s announcement were about 40 basis points below their previous 60-year low and almost two percentage points below their trailing five-year average, according to research from Oppenheimer.
Travelers Companies said earlier this month that 10 percent of its long-term fixed income investments mature annually through 2014 at an approximate yield of 5 percent. If Travelers reinvests that in Treasuries, the yield is likely to be two to three percentage points lower.
The prospect of anemic returns may be one reason why insurance shares have underperformed the broader market in six of the last seven months.
Shares were broadly lower after the Fed’s announcement.
Several insurers that were hoping for moderate interest-rate relief by now may consider higher-risk investment alternatives eventually, though not yet.
Deutsche IAM said some insurance clients have been seeking to invest in bank loans and other alternatives to traditional stocks and bonds if they could find yields higher than 3 percent, though their appetite has cooled.
“With the recent volatility in the marketplace and the recent sell-off and concern about risk there’s been a bit of a pullback in the interest in those asset classes,” Deutsche’s Staples said.
Most everyone agrees that insurers can sustain themselves during a prolonged period of low rates and meet their obligations through their cash flow rather than investment returns. But the question is what happens if rates do not rise in a few years.
“Let’s say, hypothetically, you’re in a low interest rate environment for the next five to 10 years, you’d have to say you’ve got to change your product mix, you’ve got to change what you’re selling,” Ernst & Young’s French said.
Editing by Steve Orlofsky