2017 Life Insurance Company Valuations and Interest Rates

Valuation Framework

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

The majority of the insurance industry's assets are investments in bonds and other nonequity instruments, while liabilities typically consist of products sold and the ability to meet policy commitments. Consequently, life insurance is a liability-driven business, as it is the life insurers' business to take today's funds in exchange for the promise to make payments in the future.

Business Model

The assets and liabilities of life insurers have a unique relationship. Life insurers collect premiums from policy owners, which they invest in stocks and bonds. Insurers aim to generate returns in excess of their liabilities through investment income and capital gains. This income is then shared with policyholders through annuities or the policy's cash value. Accordingly, the life insurance industry is greatly influenced by its exposure to the financial sector.

As a result of this business model, life insurers' assets and liabilities are heavily exposed to interest rate risk. Earnings are dependent on the spread between investment returns and the interest paid on each insurance policy or product. When interest rates are low, insurance companies may be unable to meet contractually guaranteed obligations to policyholders solely from investment income. ² As such, insurance companies strive to match liability cash flows with cash flows from investment earnings in order to avoid an asset-liability reserve. However, when interest rates are too low, the cash flows may not correlate, exposing insurers to losses from the sale of assets that did not have adequate returns. In these instances, companies will typically see a negative impact on earnings.

Interest Rate Effect on Earnings

As a result of changes in interest rates, 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. A majority of this investment income is related to fixed-income securities. The prices and returns of these securities are highly dependent on interest rates. For example, high interest rates allow insurers to generate more investment income from fixed-income securities due to higher yields. In contrast, low interest rates reduce investment earnings because the income is being reinvested at a lower rate, exacerbating the earnings spread compression. ³ Persistent low rates, like those experienced over 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 favorable interest rates. As interest rates rise, the disintermediation risk grows as policyholders have the opportunity for greater returns if they withdraw funds from their policy and invest them elsewhere.

During the past few years, interest rates have remained relatively low. However, interest rates are anticipated to increase in the near future, although the increase is not definitive due to the Federal Reserve's fluctuating projections. ⁴ Thus, while it does not appear that disintermediation risk will be a near-term problem for life insurers, it will depend on the magnitude and speed of the interest rate hikes by the Federal Reserve in the coming months.

Interest Rate Effect on Products and Consumers

Life insurers are exposed to interest rate risk based on the behavior of policyholders. Policyholders will choose certain insurance products with the insurance rate environment in mind. Three of the most popular life insurance products include fixed annuities, lump-sum payments, and deposit-type investments.

A fixed annuity promises a specified return on investments for an extended period of time. As liquidity demands decrease, policyholders will want to keep money in a more secure investment vehicle, such as the annuities offered in many life insurance products. Additionally, when rates are low, life insurers only profit from these annuities if the annuity's contracted return is lower. Accordingly, there is less demand for these products in a low interest rate environment, making it difficult for insurers to sell. ⁵

In addition, some life insurance policies allow a beneficiary to receive a lump-sum payment upon a policyholder's death. A decline in interest rates will cause a policy's future payments to be covered more from asset sales than investment income, increasing the insurers' liability. ⁶

Lastly, deposit-type products include guaranteed investment contracts and funding agreements, which are primarily sold to institutional clients. These products function like a bank certificate of deposit, with policyholders able to receive interest and principal repayment in the future. These products are solely a savings vehicle.

Managing Interest Rate Risk

Because interest rate volatility can pose a threat to the cash flow of life insurance companies, it is important for insurers to manage this interest rate risk. Many insurance companies have created several tools to help address the risk of low interest rates.

One strategy for addressing this risk is duration matching. ⁷ Duration is defined 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." ⁸ The concept of duration involves matching asset duration to liability duration in order to limit insurers' exposure to interest rate risk. By matching the durations, the price sensitivity of surplus-to-interest rates is reduced. Increasing the duration of assets allows companies to better match assets with liabilities, which is one of the insurers' key risk mitigation strategies. ⁹ However, it is oftentimes difficult or impossible for insurers to match the duration of the liabilities, as assets with equivalent maturities are not always readily obtainable. ¹⁰ As such, greater duration mismatch creates greater risk for the insurer.

Interest rate risk can also be managed through diversification of products and investments. Large insurers are more capable of managing risk through diversifying assets. Insurers can balance interest-sensitive offerings with noninterest rate sensitive products. In recent years, with unusually low rates on treasuries, 48.5 percent of the industry's investment income came from bonds, followed by stocks at 32.4 percent. In addition, investment income can come from mortgage loans, contract loans, and real estate holdings. ¹¹ Insurers also invest in derivatives such as fixed-income futures and interest rate floors, swaps, and swaptions to mitigate the risk of prolonged low interest rates. ¹² Life insurers use derivatives to reduce risk and hedge against losses in the future. ¹³ By using derivatives, a life insurer with a large portfolio of guaranteed death benefit annuities has the ability to hedge against declines in the equity markets.

Although insurers attempt measures to manage interest rate risk, the extent that they can mitigate this risk is limited, particularly in an environment of prolonged low interest rates. In these situations, insurers will typically lower guaranteed rates on new policies in order to reduce expected future liabilities. ¹⁴ However, the persistence of low interest rates also forces insurers to reinvest at lower rates, exacerbating the effect. ¹⁵ Although interest rates are projected to gradually rise, the historically low interest rate environment is anticipated to continue into 2017 given the uncertainty in the markets. If interest rates continue to remain low, life insurance companies may experience significant losses as companies may lose the ability to satisfy obligations with investment income alone and may have to sell assets at depressed values. For example, Kansas City Life Insurance Company announced in its press release for its 2016 second quarter earnings results that its decline in net income from $10.9 million in the second quarter of 2015 to $5.2 million in the second quarter of 2016 "resulted from increased policyholder benefits and lower investment income, both of which were affected by the challenging interest rate environment." ¹⁶

Interest Rate Effect on Valuation Multiples and Current Trends

One metric that 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 can be changed by the interest rate environment.

To analyze the effect of the interest rate environment on the valuation multiples of life insurance companies, we analyzed the following publicly traded companies (the "life insurance industry group") as we considered them representative of the industry as a whole.

• Aflac, Inc.
• CNO Financial Group, Inc.
• Lincoln National Corp.
• Manulife Financial Corp.
• MetLife, Inc.
• National Western Life Insurance Co.
• Principal Financial Group, Inc.
• Prudential Financial, Inc.
• Sun Life Financial Inc.
• Torchmark Corp.

The following graph compares P/E multiples to 20‑year treasury bond rates and suggests that during periods of prolonged low interest rates, there is more perceived risk for life insurance companies. Slight increases in interest rates seem to promote confidence in the financial stability of these companies, as reflected in higher P/E multiples.

While still below historical levels, interest rates have been rising in the last few months, allowing fixed-rate annuities and similar products to perform better. The interest rate effect is at least partially due to the fact that life insurance companies are long-term investors with a low tolerance for risk. Accordingly, life insurers typically use fixed-income securities to earn returns. With much of the insurers' investment income relating to fixed‑income securities, returns are highly sensitive to interest rate movements. However, other factors also affect this general trend. For example, improvements in the Standard and Poor's 500 index caused the spike in the P/E ratio in 2013, which carried over into 2014. ¹⁷

Current Trends

Interest rates have increased since August 2016, as illustrated below.

Investment income has grown recently with gradually rising interest rates. ¹⁸ Furthermore, when put in a global context, US interest rates are considered high as interest rates in other areas of the world are near zero and, in some cases, negative. For instance, Japan has been operating in a negative interest rate environment since the beginning of 2016. In a negative interest rate environment, banks are charged a fee by the central bank to hold unused cash to encourage banks to deploy that money more effectively by lending to households and businesses. ¹⁹ However, life insurance companies generally invest in long duration government bonds, and more than 70 percent of Japan's government bonds are longer than 10 years. ²⁰ Due to the negative interest rate environment, yields on these long duration bonds have been negative as well, forcing Japanese life insurers to look abroad to foreign assets to enhance profitability. ²¹ As a result, over the past 2 years, several Japanese life insurers and diversified holdings companies have acquired American insurers.

Outlook

Interest rate volatility can pose a significant challenge to insurers, so understanding the impact of rate changes is important. Most insurers perform poorly in very high or very low interest rate environments. A more ideal situation for life insurers is for rates to gradually return to "normal" levels. ²²

2017 is expected to be a year of continued tests for the life insurance industry due to regulatory pressures regarding consumer protection, capital, and cyber-security. ²³ For example, policy changes are being implemented by certain states requiring insurers to hold higher capital reserves in 2017. ²⁴

Despite these challenges, life insurers are expected to experience moderate growth over the next 5 years as stronger financial markets, a stabilized economy, and anticipated interest rate hikes are projected to support higher investment income. ²⁵ Based on its December 14, 2016, meeting, the Federal Reserve's aim is to raise the federal funds rate from 0.6 percent to 2.1 percent by 2018. ²⁶ The higher interest rate returns on both bonds and debt-market securities will allow insurance companies to generate more investment income as a result of higher yields and foster improvements in the financial performance of the life insurance industry. ²⁷ Additionally, growth in household wealth and an aging domestic population, among other factors, are anticipated to support investment income and growth in industry revenue at an annualized rate of 2.3 percent. ²⁸ Once interest rates rise, life insurers' cash flows should improve, relieving pressures on reserve requirements and helping insurers recover to their previous capital positions. ²⁹