A.M. Best Chief Rating Officer: Life and Annuity Insurers Respond to Reserving, Product Changes
January 30, 2017 by Best's News Service
OLDWICK, N.J. – A.M. Best Chief Rating Officer Stefan Holzberger outlined highlights from A.M. Best’s annual Review/Preview report on the life and annuity sector, including the introduction of principle-based reserving for new business, regulatory changes and insurers’ efforts to more closely tie products to the interest rate environment.
View the video version of this interview at: http://www.ambest.com/v.asp?v=lifeannuity117
Following is an edited transcript of the interview.
Q: How are life and annuity writers dealing with the low interest rate environment and challenges, especially in the way of reserving?
A: Well, 2017 marks the implementation of principles-based reserving. This is going to be a shift for the life and annuity sector. Prior to this year, reserves were set on a deterministic basis. This will be a shift and it will have risk management implications for the market. It could also mean interest rate hedges becoming more prevalent in this sector. It’s important to remember that principles-based reserving is going to be in effect for new business. The vast legacy blocks of reserves that are held by life and annuity writers, they won’t be affected. It will be on a going-forward basis, and over the years this will become more material.
Reserves are certainly an issue for companies in this sector in the low interest rate environment. Take long-term care, for example, where we’ve seen very significant reserve increases, partially due to interest rates, and also due to higher morbidity levels and lower lapse rates than anticipated. But you’ve also got the risk surrounding variable annuity business where we’ve seen some voluntary increases in reserves on the financial statements according to GAAP and IFRS.
Another notable product in the life and annuity sector is fixed indexed annuities, where by and large this product is somewhat insulated from the volatility or the risk associated with interest rates, due to the ability to set crediting rates on an annual basis. More prevalent in the area of fixed index annuities are these products with living benefits. There you do have that enhanced interest rate risk. We are seeing life and annuity writers pivoting their products so that for annuity products, including variable annuities and fixed indexed annuities, they’re correlating the crediting rates much more closely with interest rates. These organizations are able to match the liability with floating rate assets and, in that form, manage the movement of interest rates over time.
Q: With this new administration, is there a concern regarding deregulation, especially when it comes to the Department of Labor’s fiduciary rule?
A: If you consider the potential for deregulation, rolling back the regulation that’s come through over the last four to eight years, it’s really not a concern for A.M. Best. We see the state system of regulation as very sound. It’s served its purpose well over a number of years. Of course, you do have a level of inconsistency from one state to the next. They’re referred to as permitted practices. At A.M. Best we try to level the playing field. We look at these permitted practices and try to level set profitability, risk-adjusted capitalization so that when our peer analysis is conducted among these companies that operate in different states we’re not giving one an advantage or a disadvantage in the context of permitted practices.
If you look at other areas of regulation, the Department of Labor’s fiduciary rule, we feel that overall it’s a positive. It’s going to probably bring some outliers in line in terms of sales practices. Overall, that is a positive we feel for the market. There are going to be costs associated with compliance and marketing, and ultimately that could find its way to the policyholder which would be negative. The other potential issue of course is the ramp-up of compliance costs. The compliance requirements associated with this new rule could lower the number of financial advisers available to help consumers work through their retirement needs. One last point on the DOL rule: it does affect the distribution channel much more so than the insurance companies who are manufacturing the products.
Q: Does A.M. Best expect to see more spin-offs in 2017 like MetLife-Brighthouse or is that an isolated incident?
A: MetLife has been battling with the federal regulators over the non-bank SIFI designation. MetLife has stated that this spin-off is not directly tied to trying to persuade the federal regulators to remove them from the list of SIFIs. But their stated rationale for this action is to take some businesses that are inherently more volatile, more capital intensive, where you’ve got a longer payback period to earn out that level of profitability than the remaining business; to separate that out. It seems to them to be a prudent strategy in terms of managing the risks inherent in those two segments of their business. Of course, shedding such a large block of their business probably will argue well for being removed from the SIFI designation.
Q: A.M. Best revised its outlook of the sector to negative this year. What risk posed the greatest threat to the credit quality of insurers?
A: For life and annuity writers there’s certainly risk on the liability side of the balance sheet. You’ve got risks around morbidity and increasing longevity. But our main area of focus today is on the asset side of the balance sheet. We see a downward migration in terms of credit quality from the investment portfolio, also a reduction in liquidity. We see over a number of years life and annuity writers are migrating down the credit ladder within an asset class. Take NAIC Class II, now we’re seeing a shift toward the lower end of the BBB range. These companies are also going farther out in maturities with fixed-income maturities now at 10-plus years. You have the reduction in overall credit quality in the portfolio, and add to that less liquidity. We see more private placements taking a large amount of room in terms of the investment allocation. Structured securities such as CLOs are much more prevalent, as are real estate investments; traditional commercial loans, as well as senior and mezzanine debt funds, REITs, things of that nature. It is definitely a “risking up” on the investments. It’s something at A.M. Best we’ll be following very closely.
View this and other interviews at http://www.ambest.tv
(By John Weber, senior associate editor, A.M. BestTV: John.Weber@ambest.com)
