Rising to the occasion: in the recession's wake, term life insurance writers hike premiums for the first time since 1995.
Through August 2009, the premium for a $500,000 policy for a 35-year-old man with a rate guaranteed for 20 years rose 5% on average and the premium for a policy with a 10-year guarantee was up 6%. Some leading companies raised term insurance premiums by as much 10% to 15% last year and others have stopped writing long-term business.
This reverses a decade-and-a-half trend of falling premiums. From 1995 to 2001, premium rates fell by 19%, and from 2001 to 2008 they dropped another 10% to 20%. Mortality experience only partially explains this decline. From 1995 to 2001, U.S. mortality rates decreased by 6% while term premiums fell 19%. Other contributing factors include expense reductions, declines in capital and collateral costs and the availability of attractively priced mortality reinsurance.
Two factors are fueling the current rise in term insurance prices: reserve requirements and fallout from the financial crisis. Term insurance ultimately must be priced at a level that allows providers to assure their sustainability by covering costs and earning a competitive return on invested capital. In recent years, outdated regulations and economic challenges have pressured insurers to take necessary steps to remain profitable.
In 2000, when Regulation XXX introduced higher reserve requirements for level-term products, the industry reduced costs by using bank letters of credit to help fund reserves. These letters pose additional risks for insurers. Most are for one year and, although renewable, they may become unavailable or more expensive should the condition of the lender or borrower deteriorate.
Additional capital market solutions eventually supplemented letters of credit, but they also relied on the availability of low-cost collateral, which disappeared with the onset of the financial crisis. As funding became less available, companies were forced to either retain the higher reserves that Regulation XXX mandates or pay a higher price for funding.
Because it is based on industry-prescribed assumptions rather than company-specific best estimates, Regulation XXX sets reserve requirements well above what principles-based economic reserve calculations would indicate. Although the magnitude of this redundancy varies by product and company, estimated Regulation XXX reserves are more than double economic reserves (see Figure 1, page 91).
Reserve requirements in other markets underscore this point. In recent years, countries such as the United Kingdom, Australia, South Africa, the Netherlands, Switzerland and Canada have aligned their reserve requirements more closely with principles-based economic reserves. For example, the reserves for 20-year term required by Swiss regulators--not known for excessive optimism--are much closer to economic reserves than to Regulation XXX reserves (see Figure 2, page 91).
Impact of the Recession
The fallout from the economic crisis has sharply raised the cost of funding redundant reserves, creating a new financial reality to which life insurers should adjust. As National Economic Council Director Lawrence Summers has noted, "Our problems were not made in a day or a month or a year, and they will not be solved quickly."
The crisis has altered the economics of writing level-term insurance coverage by:
1 Depleting industry capital. Investment losses have eroded the industry's capital and surplus, which declined by 14%, from $312 billion to $269 billion, from the start of 2008 to mid-2009. Life insurers likely will suffer additional asset impairments from debt defaults and investment downgrades. Reinsurers, a vital financing source, have also suffered large declines in capital that limit their capacity.
2 Increasing funding-reserve costs. Capital market solutions for funding reserves have been unavailable for the past two years as monoline problems, credit risk and collateral issues, and widening asset-backed security spreads have disrupted the market severely. The most recent public XXX/AXXX securitization closed in July 2007. Bank letters of credit, another important mechanism for funding redundant reserves, have become far less available and more expensive because capital deterioration at banks has eroded their lending capacity. Letter-of-credit pricing relates to credit market risk spreads, which, though down in recent months, remain five-to-six times above early 2007 levels (see Figure 3, page 92). The representative price of bank credit letters, where available, rose from 40 to 50 basis points prior to the crisis to approximately 250 basis points at its peak.
3 Lowering investment yields. Another factor impacting the profitability and pricing of term insurance is an ongoing decline in the life industry's investment yield, from 8.4% in 1991 to 6.6% in 2001 and 5.4% in 2008 (see Figure 4, page 92). Reserve capital is mostly invested in fixed-income securities that earn a premium over Treasury yields, such as corporate bonds. Lower interest rates mean that insurers must set aside more capital to cover policy risks, an effect especially pronounced for long-duration term products. Ten-year U.S. Treasury bond yields have been trending downward for decades, from 8% to 9% in 1990 to well below 4% today (see Figure 5, page 92).
4 Raising target return on investments. As industry capital has been depleted, the cost of capital has risen, and many life companies have been hard-pressed to raise funds. This has forced them to allocate their capital more carefully. One way is to increase the target return on investment for new business.
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Impact on Pricing
Do this year's increases in level-term product prices fully reflect the new economic realities, or are further steps in order? The answer will vary from one company to the next, depending on their circumstances and approach. To clarify the issue, Swiss Re used a standard, simplified pricing model to examine the impact on term pricing of increased reserve funding costs, lower investment yields and higher target returns on investment. All other factors were held constant. The model considers a 20-year level-term policy for a 35-year-old, male nonsmoker who is a preferred risk.
In this base case, which reflects pre-crisis conditions, the 10-year Treasury bond rate is 4.4% (its 2003-2007 average) and letters of credit cost 100 basis points. In the wake of the market turmoil, U.S. Treasury bond yields declined to an average of 3.2% in 2009 (through September).
According to the pricing model, this change alone means that premiums must rise by 4.2% to offset lower investment yields (see Figure 6, page 93).A rise in costs of letters of credit, from 100 bp to 250 bp, implies premiums that are an additional 6.6% higher. Finally, a company whose increased capital costs lead it to raise target ROI by 2% would need to raise prices by another 1.6%.
This analysis indicates that this year's price increases are justified by new economic realities, and suggests that the upward trend in pricing will persist in the near term unless other steps are taken. To minimize rate increases, companies might consider revamping products and working to expedite the transition to a principles-based approach.
Because products with long-term guarantees have become more expensive, insurers can scale back these offerings and emphasize shorter-duration term products with fewer guarantees.
The industry should also intensify its efforts to expedite the transition to a principles-based approach for setting capital and reserving requirements. The principles-based approach quantifies company-specific risks with respect to individual products, eliminating the need to hold redundant reserves. Despite the efforts of regulators and actuaries, principles-based reserving is unlikely to be initiated before 2012.
Regulators have taken some positive steps in the wake of the financial crisis, but these measures are no substitute for filly implemented principles-based reserving, which would provide a consistent approach to dealing with reserve redundancies. Prior to 2008, when capital was abundant, collateral costs low and securitization a viable option, the costs of redundant reserves were less burdensome. Today, these excessive reserve requirements are severely straining life insurers.
What is needed is principles-based reserving which, like the approaches taken in other insurance markets throughout the world, sets reserves based on economic necessity.
Our economy is recovering from the most severe financial crisis since the Great Depression. Although economic conditions should return to normal eventually, no one knows when. Challenges, such as massive debt defaults, remain.
Even after the economy has returned to normal, however, financial markets will have changed. Insurers should therefore continue to adapt to the new financial realities.
(To read Swiss Re's report, Why Term Life Prices Must Rise, in its entirety, visit www.swissre.com.)
* The Latest' Term life policy premiums are rising again due to financial pressure on insurers.
* The Background" Term life rates had been on a 15-year slide until the recession hit in 2008.
* The Way Ahead; A changed financial landscape will challenge carriers to meet Regulation XXX requirements.
Swiss Re Life & Health America Inc.
A.M, Best Company # 07283
Distribution: Reinsurance brokers
For ratings and other financial strength information visit www.ambest.com.
Frank O'Neill is managing director at Swiss Re Life & Health America; Kurt Karl is chief U.S. economist at Swiss Re; and David Laster is senior economist at Swiss Re. They may be reached at frank_oneill@ swissre.com; firstname.lastname@example.org; and email@example.com.
Figure 6: Price Impacts Of Changes in Market Conditions (%) Higher target return on investment 1.6 Higher cost of collateral 6.6 Lower investment yields 4.2 Notes: Product examined is 20-year level term, age 35, best preferred male nonsmoker. Assumes 10-year Treasury yield declines from 4.4% to 3.2%, collateral costs rise from 100 bp to 250 bp and target ROI rises by 2%. Source: Swiss Re Life & Health estimates Note: Table made from bar graph.
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|Title Annotation:||Life: Term Insurance|
|Comment:||Rising to the occasion: in the recession's wake, term life insurance writers hike premiums for the first time since 1995.(Life: Term Insurance)|
|Author:||O'Neill, Frank; Karl, Kurt; Laster, David|
|Date:||Apr 1, 2010|
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