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The effects of negative interest rates on the life insurance financials.

ABSTRACT

Extremely low or negative interest yields of fixed-income securities present significant hazards for life insurance firms. To address stringent regulations, life insurance firms invest a significant proportion of the security premiums in interest-bearing long-term debt instruments. The authors of this study discuss the adverse effects of negative interest rates for a hypothetical insurance firm and provide calculations to show how the premiums on life insurance products and policy reserves may be changed to mitigate the effects of negative interest rates.

Keywords: Negative interest rates, life insurance, policy reserves, fixed-income securities,

INTRODUCTION

The persistence of the recent phenomena of extremely low or even negative interest rates in world financial markets have begun to worry specialists in the life insurance sector (Davies, 2016; Hegge, 2016; the National Association of Insurance Commissioners, 2016). As life insurance firms hold a large portfolio of fixed-income securities, a concern exists that low or negative interest rates of long-term bonds may adversely affect an insurance firm's financials, earnings, capital, and reserves.

The competitiveness of insurance whole-life saving products that promise guaranteed returns over long periods has also become a concern for firms. Due to extremely low or negative interest rates, the guaranteed positive interest rates for these products may not be a feasible offering. It is also likely that the life insurance sector may suffer a significant and substantial decrease in demand for guaranteed savings insurance products. A 2016 publication provided by the National Association of Insurance Commissioners (NAIC), a regulatory support organization, briefly summarizes the problems associated with the negative interest rate environment:
The recent low interest rate environment has been a key concern for
U.S. life insurers. Life insurance companies face considerable interest
rate risk given their investments in fixed-income securities and their
unique liabilities as their assets and liabilities are heavily exposed
to interest rate movements. Interest rate risk can materialize in
various ways, impacting life insurers' earnings, capital and reserves,
liquidity and competitiveness.


Beyond the current concerns about the low or negative interest rates, the academic literature analyzing the financials of life insurance firms are limited. Some provide a variety of examples of insurance company-specific transactions and required financial statement entries (Mooney et al., 1995; Rejda, 2011; Vaughan & Vaughan, 2008; Santos & Richman, 2015). An on-line slide presentation (Miles, 2006) illustrates how a minor change in policy reserves can have a major impact on an insurance company's financials; however, the examples provided in the slide are not well developed. Unfortunately, no prior publication specifically explores the effects of negative interest rates on insurance firm financials. Although Santos et al. (2016), analyzes the effects of interest rates changes for a hypothetical life insurance firm, the analysis does not consider the low or negative interest rate environments.

To address the dearth of information concerning the impact of low or negative interest rate environments on life insurance firms, the current study addresses these concerns using examples which impact a fictitious stock life insurance firm, the "Trinity Life Insurance Corporation (TLIC)" in Tables 1-7.

BALANCE SHEET ENTRIES FOR THE TRINITY LIFE INSURANCE CORPORATION

As noted, TLIC raises capital by issuing 200,000 common stock shares at $100 per share for a total equity capital of $20,000,000 ($100 per share x 200,000 shares). Table 2, reflects the transaction on December 31, 2015 as a debit to "Cash" under Assets, and a credit to "Capital" under Liabilities and Surplus. The firm has not started operations as of this date, therefore "Policy Reserves" equal $0.

Table 3 reflects transactions at the beginning of operations January 1, 2016. On that date, the firm collects $21,500,000 in premiums from 100,000 identical 10-year level term-life contracts at an annual premium of $215 per contract. The face value of each contract is $100,000, and all contracts are purchased by 40-year old females. On the balance sheet, this transaction is recorded as a $21,500,000 addition to the existing $20,000,000 in the Cash and Investments account for a total of $41,500,000.

The formula to calculate policy reserves is:

Policy Reserves = Present Value of Total Expected Future Death Benefits Payable--Present Value of Total Expected Future Premiums Receivable

Regulatory mandates require the firm to set aside a portion of the $21,500,000 received in premiums as policy reserves. Based on the formula located directly below Table 3, the firm allocates $4,873,896 for reserves for 2016 as shown in Table 3. This entails a credit to the policy reserves account on the balance sheet, and $16,626,104 remains from the collected premiums ($21,500,000 premiums-$4,873,896 reserves) which are credited to the Surplus account.

Determining the 2016 policy reserves amount for TLIC requires applying the formula to the appropriate row of actuarial estimates in Table 4. The table uses death probabilities over a 10-year period for 40-year-old females as estimated by the Social Security Administration. The amounts shown under Present Value of Total Future Death Benefits Payable, Present Value of Total Future Premiums Receivable, Policy Reserves, and Expected Losses are calculated totals for the 100,000 policyholders.

For Trinity Life Insurance Corporation, 2016 is assumed to be Year 1, when policyholders are at age 40. Applying the formula to the items in that row yields a policy reserves amount of $4,873,896 reflected on the balance sheet in Table 3, and Column 6 of Table 4.

INCOME STATEMENT ENTRIES FOR THE TRINITY LIFE INSURANCE CORPORATION

Trinity Life Insurance Corporation's transactions impact both the firm's balance sheet as well as its income statement. Table 5 demonstrates changes to the firm's income statement after one year of operations. Revenues total $21,500,000 ($21,500,000 in premiums + $0 in interest earnings as calculated in Table 1 above). Expenses include $12,870,000 in expected losses, $4,873,896 in changes in reserves, $1,287,000 in operating expenses [(0.10) x $12,870,000 in expected losses], and $645,000 in premium.

Taxes [(0.03 state tax rate) x ($21,500,000)]. Earnings before taxes (EBT), the difference between revenues and expenses equal $1,824,104. Deducting Federal Taxes of $547,231 [(0.30 corporate tax rate) x ($1,824,104)] from EBT yields a net income figure of $1,276,873. The firm then pays out $100,000 in Dividends ($0.50 per share x 200,000 shares), resulting in Retained Earnings of $1,176,873.

LOW AND NEGATIVE INTEREST RATES AND LIFE INSURANCE FINANCIALS

Table 6 illustrates the effects of low and negative interest rates on TLIC's Net Income and EPS using 1% incremental changes in interest rates ranging from a high of 2% to a low of -2%. This example assumes that TLIC is a profitable firm with $1,276,873 of net income and $6.38 of earning per share (EPS) even in a 0% interest rate environment, as shown in bold in Table 6. An increase in interest rates from 0% to 1% results in a reduction in required policy reserves from $4,873,896 at a 0% interest rate to $2,348,564 at 1%, a drop of 51.81% or $2,525,332.

This reduction in policy reserves results in a significant increase in net income from $1,276,873 to $3,335,105, and an increase in EPS from $6.38 to $16.68, a change of $10.29 or 161.19% increase. Conversely, in a -1% negative interest rate environment, the rate drop from 0% to -1% results in a significant increase in reserve requirements from $4,873,896 to $7,741,576, and significant decreases in net income from $1,276,873 to -$1,021,003. EPS falls from $6.38 to -$5.11. Similar effects are observed when interest rates drop from a level of -1% to a level of -2%.

Importantly, Table 6 demonstrates that when premiums are fixed, any negative interest rate has significant adverse effects on the profits of TLIC through required increases in policy reserves and the resultant reduction in net income.

Table 7 demonstrates the adjustments in additional premium or policy reserves required at negative interest rates to ensure TLIC remains as profitable as it was during the period of 0% interest rates when EPS were fixed at $6.38. Column 2 of Table 7 shows that a 1% drop in interest rates from 0% to -1% require a premium increase of $3.17 per policy, from $215 to $218.17. Additionally, to keep TLIC at an EPS of $6.38 level of profitability, policy reserves slightly adjusts from $4,873,896 to $4,763,443. Similar effects are observed when interest rates drop from a level of -1% to a level of -2%.

Observations from Tables 6 and 7 provide further insights for ways how a life insurance firm can mitigate the impact of low or negative interest rate effects on the profitability. One viable option is to increase premiums for the life insurance policies and make minor reserve adjustments. Increasing the price of required premiums may come at a cost to the firm however, possibly by reducing demand for the insurance products and a resultant reduction in total revenue realized through sales volume. As noted by both Davies (2016) and Hegge (2016), offerings of whole life insurance products with guaranteed interest rates may not be sustainable by insurance firms due to the adverse financial impacts triggered in low or negative interest environments.

CONCLUSION

The adverse effects of negative interest rates are widely touted in the financial media. The media outlets claim that the problem stems from the regulatory environment requiring life insurance firms to invest a significant portion of policy premiums in fixed income securities. Therefore, it is concluded that the lower or negative interest rate environments reduce interest earnings of the life insurance firms adversely affecting profitability.

This study provides evidence that, in the short run, relatively small increases in premiums can mitigate the adverse effects of negative interest rates on the firm profitability. Also, we find that the increases in premiums should result in minor changes in policy reserves.

However, our paper does not answer questions regarding to the long-term effects of negative interest rates on life insurance industry. We expect that the life insurers may limit the product offerings with guaranteed interest rates and therefore lose some of the revenues obtained from the whole life market segment. Therefore, in the long run, the reduced demand from higher premiums because of negative interest rates coupled with the reduction of the whole life insurance products offering with guaranteed interest rates may limit the competitiveness of life insurance firms.

REFERENCES

Actuarial Life Table (2010) for the Social Security area population. Retrieved January 28, 2017, from http://www.ssa.gov/oact/STATS/table4c6.html

Davies, P. J. (2016). Negative Rates and Insurers: Be Afraid, The Wall Street Journal (Online); New York, N.Y., Published on March 3, 2016.

Hegge, P. (April 7, 2016). Low or negative rates--Implications for Insurers. Allianz Investment Management SE. Frankfurt. Retrieved on January 28, 2017, from https://www.ecb.europa.eu/paym/groups/pdf/bmcg/160407/2016-04-7_ Item_2_2_Impact_of_low_or_negative_interest_rates-investor_perspective.pdf

Miles, J. (October 5, 2006). Reserves (PowerPoint), Department of Mathematics. Retrieved July 8, 2015, from http://www.math.purdue.edu/search?q=reserves

Mooney, S., Cohen, L., & Addison S. (1995). Basic Concepts of Accounting and Taxation of Property/Casualty Insurance Companies (Fourth Edition). New York, Insurance Information Institute.

NAIC. (2016). Low Interest Rates. Retrieved January 28, 2017, from http://www.naic.org/cipr_topics/topic_low_interest_rates.htm

Rejda, G. E. (2011). Principles of Risk Management and Insurance (Eleventh Edition). Prentice Hall.

Santos, M. R., & Richman V. (2015). A teaching note for the risk management and insurance instructors and students: SAP accounting example for a property & casualty firm, Journal of Finance and Accountancy, 18, 1-7.

Santos, M. R., Richman, V., & Baltazar, R. (2016). Academy of Educational Leadership Journal 20(2), 43-50.

Vaughan, E. J., & Vaughan, T. (2008) Fundamentals of Risk and Insurance (Tenth Edition). John Wiley & Sons, Inc.

Michael R. Santos

John C. Urbanski

Sonoma State University, Rohnert Park, California

Vincent Richman

Sonoma State University, Rohnert Park, California Dalhousie University, Halifax, Canada

About the Authors:

Michael R. Santos is a Professor of Finance at the School of Business and Economics at Sonoma State University, Rohnert Park, California. Dr. Santos's research interests include event studies, pedagogy of finance, wine business and finance, and risk management applications for the insurance firms.

John Urbanski is an Associate Professor of Management at the School of Business and Economics at Sonoma State University, Rohnert Park, California. Dr. Urbanski's research interests include organizational behavior phenomena at the entrepreneurial and small business level, impact of diverse immigrant workforces on organization processes and cross-cultural management.

Vincent Richman is a Professor of Accounting at the School of Business and Economics at Sonoma State University, Rohnert Park, California. Dr. Richman's research interests include accounting implications of health sector, pedagogy of accounting, wine business and accounting, and SAP accounting for the insurance firms.
Appendix I
PV of Total Benefits, PV of Total Premiums, Policy Reserves and Change
in Reserves

YEARS   PV of     PV of    Policy Reserves (*)  Change in Reserves
       Benefits  Premiums

  1    1967.79   1919.05          48.74               48.74
  2    1839.09   1704.33         134.76               86.02
  3    1699.97   1489.90         210.07               75.30
  4    1548.68   1275.80         272.87               62.81
  5    1383.17   1062.06         321.11               48.24
  6    1201.54    848.71         352.83               31.72
  7    1002.58    635.78         366.79               13.96
  8     784.90    423.33         361.57               -5.22
  9     546.55    211.38         335.17              -26.40
 10     285.51      0.00         285.51              -49.65

(*) Estimates are based on a one 10-year Term-Life Contract for a
40-year female paying $215 annual premium, and an interest rate of 0%.

Appendix II
PV of Calculations for the Total Benefits

YEARS   PVB (*)   Year 1   Year 2   Year 3   Year 4   Year 5   Year 6

 1      1967.79   128.70     0.00     0.00     0.00     0.00     0.00
 2      1839.09   139.12   139.12     0.00     0.00     0.00     0.00
 3      1699.97   151.29   151.29   151.29     0.00     0.00     0.00
 4      1548.68   165.50   165.50   165.50   165.50     0.00     0.00
 5      1383.17   181.63   181.63   181.63   181.63   181.63     0.00
 6      1201.54   198.96   198.96   198.96   198.96   198.96   198.96
 7      1002.58   217.68   217.68   217.68   217.68   217.68   217.68
 8       784.90   238.35   238.35   238.35   238.35   238.35   238.35
 9       546.55   261.04   261.04   261.04   261.04   261.04   261.04
10       285.51   285.51   285.51   285.51   285.51   285.51   285.51
TOTALS           1967.79  1839.09  1699.97  1548.68  1383.17  1201.54

YEARS    Year 7  Year 8  Year 9  Year 10

 1         0.00    0.00    0.00     0.00
 2         0.00    0.00    0.00     0.00
 3         0.00    0.00    0.00     0.00
 4         0.00    0.00    0.00     0.00
 5         0.00    0.00    0.00     0.00
 6         0.00    0.00    0.00     0.00
 7       217.68    0.00    0.00     0.00
 8       238.35  238.35    0.00     0.00
 9       261.04  261.04  261.04     0.00
10       285.51  285.51  285.51   285.51
TOTALS  1002.58  784.90  546.55   285.51

(*) PVB refers to Present Value of Benefits Payable at the end of the
year by the insurance firm. All entries apply to one 10-year term-life
contract assuming the interest rate is 0%. The entries in the shaded
area are calculated by using probabilities from the Actuarial Life
Table (2013) at the Social Security Administration website shown on
Table 4. For example, the number, $128.70 (at the third column and
second row intersection), is calculated from (0.001287) x (100,000)
/ (1+0%) ^1 where $100,000 is the face value of the life insurance
contract. Similarly, the number, 139.12 (at the third column and third
row intersection), is calculated from (1-0.001287) x (0.001393) x
(100,000) / (1+ 0%) ^2. Again, interest rate is assumed to be 0%.

Appendix III
PV Calculations for the Total Premiums

YEARS   PVP (*)    Year 1    Year 2    Year 3    Year 4    Year 5

 1      1919.05      0         0         0         0         0
 2      1704.33    214.72      0.00      0.00      0.00      0.00
 3      1489.90    214.42    214.42      0.00      0.00      0.00
 4      1275.80    214.10    214.10    214.10      0.00      0.00
 5      1062.06    213.74    213.74    213.74    213.74      0.00
 6       848.71    213.35    213.35    213.35    213.35    213.35
 7       635.78    212.92    212.92    212.92    212.92    212.92
 8       423.33    212.46    212.46    212.46    212.46    212.46
 9       211.38    211.94    211.94    211.94    211.94    211.94
10         0.00    211.38    211.38    211.38    211.38    211.38
TOTALS           1,919.05  1,704.33  1,489.90  1,275.80  1,062.06

YEARS   Year 6  Year 7  Year 8  Year 9  Year 10

 1        0       0       0       0        0
 2        0.00    0.00    0.00    0.00     0.00
 3        0.00    0.00    0.00    0.00     0.00
 4        0.00    0.00    0.00    0.00     0.00
 5        0.00    0.00    0.00    0.00     0.00
 6        0.00    0.00    0.00    0.00     0.00
 7      212.92    0.00    0.00    0.00     0.00
 8      212.46  212.46    0.00    0.00     0.00
 9      211.94  211.94  211.94    0.00     0.00
10      211.38  211.38  211.38  211.38     0.00
TOTALS  848.71  635.78  423.33  211.38     0.00

(*) PVP refers to Present Value of Premiums Receivable at the beginning
of each year by the insurance firm. All entries apply to one 10-year
term-life contract. The numbers in the shaded area are calculated by
using probabilities from the Actuarial Life Table (2013) at the Social
Security Administration website shown on Table 4. For example, the
number, $214.72 (at the third column and third row intersection), is
calculated from (1-0.001287) x (215) /(1+0%) ^1 where $215 is the flat
one-year insurance premium paid by the insured individual. Similarly,
the number, 214.42 (at the third column and fourth row intersection),
is calculated from (1-0.001287) x (1-0.001393) x (215) / (1+ 0%) ^2.
Interest rate is assumed to be 0%.

Table 1 Assumptions for Trinity Life Insurance Corporation Business
Operations

1. TLIC began operations January 1, 2016.
2. TLIC issues policies once at the beginning of each year, collects
   premiums at the beginning of each year, and makes loss payments at
   the end of each year.
3. Only one type policy is issued: a 10-year level-term life insurance
   policy for 40-year-old females with a face value of $100,000. The
   face value of the policy is paid to dependents if the insured dies
   within the 10-year period.
4. TLIC issues 100,000 identical10-year level term-life policies every
   year. Each policyholder pays a $215 annual premium. Annual total
   net premium is $21,500,000 ($215 per policy x 100,000 policies).
   Contracts are purchased by 40-year old females with identical risk
   characteristics.
5. TLIC is a stock insurance company, issuing 200,000 common stock
   shares with a per share price of $100. Total equity equals
   $20,000,000 ($100 per share x 200,000 shares). The firm will
   distribute $0.50 per share of dividends to its investors for the
   first year.
6. Both premiums as well as capital funds are invested for a one-year
   period at the current market interest rates of long-term bonds,
   the assumed interest rate being 0%, mirroring a low or negative
   interest rate environment. No investment income from interest
   earnings is therefore realized for the first year [(0%) x
   ($41,500,000)].
7. State laws require the firm to allocate policy reserves (also
   called "legal reserves") annually. Policy reserves estimates for
   this example are calculated using data found in the Social Security
   Administration's 2013 Actuarial Life Table.
8. TLIC has operating expenses equivalent to 10% of Expected Losses
   E(L).
9. The corporate tax rate is assumed to be 30%, and the state, or
   premium tax rate is assumed to be 3% of the total collected premiums.

Table 2
Balance Sheet of Trinity Life Insurance Corporation (Before starting
its operations on December 31, 2015)

ASSETS                     LIABILITIES AND SURPLUS

Cash          $20,000,000  Policy Reserves                         $0
                           Capital                        $20,000,000
                           Surplus                                 $0
TOTAL ASSETS  $20,000,000  TOTAL LIABILITIES AND SURPLUS  $20,000,000

Table 3
Balance Sheet of Trinity Life Insurance Corporation January 1, 2016

ASSETS                    LIABILITIES AND SURPLUS

Cash and
Investments   41,500,000  Policy Reserves (*)              4,873,896
                          Capital                         20,000,000
                          Surplus                        $16,626,104
TOTAL ASSETS  41,500,000  TOTAL LIABILITIES AND SURPLUS   41,500,000

(*) See Appendixes I, II, and III for the details of policy reserve
calculations.

Table 4
Actuarial Table for Trinity Life Insurance Corporation Showing Policy
Reserves (*)

                                          Present
                                          Value of
                         Present Value    Total Future
Years  Age  Death        of Total Future  Premiums      Policy
            Probability  Death Benefits   Receivable    Reserves (**)
                         Payable (1)      (2)           (1) - (2)

 1     40   0.001287     196,779,000      191,905,104    4,873,896
 2     41   0.001393     183,909,000      170,432,774   13,476,226
 3     42   0.001517     169,996,928      148,990,356   21,006,572
 4     43   0.001662     154,867,556      127,580,465   27,287,091
 5     44   0.001827     138,317,213      106,206,158   32,111,055
 6     45   0.002005     120,154,023       84,870,902   35,283,121
 7     46   0.002198     100,257,656       63,578,423   36,679,233
 8     47   0.002412      78,489,810       42,332,744   36,157,065
 9     48   0.002648      54,655,123       21,138,311   33,516,812
10     49   0.002904      28,551,467                0   28,551,467




Years  Expected
       Losses


 1     12,870,000
 2     13,912,072
 3     15,129,372
 4     16,550,343
 5     18,163,190
 6     19,896,367
 7     21,767,846
 8     23,834,686
 9     26,103,656
10     28,551,467

(*) 2013 estimates from the life table of the Social Security
Administration is used.
(**) See Appendix I for individualized "Policy Reserves" calculations.

Table 5
Income Statement of Trinity Life Insurance Corporation December 31, 2016

REVENUES                                 = Premium + Investment Income
Premium                      $21,500,000 = (Premium) x (# of life
                                           insurance contracts)
Investment Income                     $0 = (Interest Rate) x (Total
                                           Funds Invested)
EXPENSES
Benefits (Expected Losses)   $12,870,000 = Expected Losses for the 1st
                                           year
Change in Reserves            $4,873,896 = Change in reserves for the
                                           1st year
Operating Expenses            $1,287,000 = (0.10) x (Expected Losses)
Premium (State) Taxes = 3%      $645,000 = (0.03) x (Premiums Received)
Earnings before Taxes (EBT)   $1,824,104 = REVENUES - EXPENSES
Federal Taxes (30%)             $547,231 = (0.30) x EBT
Net Income                    $1,276,873 = EBT--Federal Taxes
Dividends                       $100,000 = (Dividends Per Share) x (#
                                           of Shares)
Retained Earnings             $1,176,873 = Net Income - Dividends

Table 6
The Effects of Low and Negative Interest Rates on Life Insurance Firm
Reserves and EPS (*)

                                     %
                      $ Change     Change        Net
Interest    Policy       in          in        Income     EPS
Rates      Reserves   Reserves    Reserves

 2%         $125,729           -  -97.42%   $5,181,590   $25.91
 1%       $2,348,564           -  -51.81%   $3,335,105   $16.68
 0%       $4,873,896                0.00%   $1,276,873    $6.38
-1%       $7,741,576  $2,867,680   58.84%            -   -$5.11
-2%                   $6,123,135  125.63%            -  -$17.95


             $     % Changes in
Interest  Changes       EPS
Rates     in EPS

 2%        $19.52     305.80%
 1%        $10.29     161.19%
 0%         $0.00       0.00%
-1%       -$11.49    -179.96%
-2%       -$24.34    -381.18%

(*) Premium is fixed and equal $215 while the interest rate changes.

Table 7
Premium and Reserve Adjustments to Keep the Profitability at the Same
Level (*)

Interest   Premium    $ Change  % Change    Policy    $ Change
 Rates    Adjustment     in       in        Reserve       in

   2%      $208.86    -$6.14    -2.86%    $5,096,175   $222,279
   1%      $211.90    -$3.10    -1.44%    $4,984,826   $110,930
   0%      $215.00     $0.00     0.00%    $4,873,896         $0
  -1%      $218.17     $3.17     1.48%    $4,763,443  -$110,453
  -2%      $221.42     $6.42     2.98%    $4,653,516  -$220,380

Interest  % Change in
 Rates     Reserves

   2%       4.56%
   1%       2.28%
   0%       0.00%
  -1%      -2.27%
  -2%      -4.52%

(*) EPS is fixed and remains equal to $6.38 at the same level of
profitability by adjusting the premiums and policy reserves.
Calculations use MS Excel's Data/What-If-Analysis/Goal seek steps to
generate premium and policy reserve adjustments to match the initial
profitability of TLIC.
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Author:Santos, Michael R.; Urbanski, John C.; Richman, Vincent
Publication:International Journal of Business, Accounting and Finance (IJBAF)
Article Type:Report
Date:Mar 22, 2017
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