Universal's joint problem: Low interest and lapse rates

Earnings reports for life insurers reveal a possible threat to future profitability: old books of universal life business. Amid a double whammy of low interest rates and fewer-than-expected policy lapses, analysts have been warily eyeing insurers' blocks of universal life insurance — particularly those policies with secondary guarantees. They are worried that contracts written when insurers could promise a certain return are threatening the profitability of the business. Third-quarter results showed that: Lincoln National Corp.'s review of its actuarial assumptions and models for its insurance products cost the company $72 million in net charges during the third quarter. A change in assumptions in order to reflect low interest rates resulted in a $114 million charge, largely attributed to Lincoln's universal life business, spokeswoman Laurel O'Brien confirmed. Still, Lincoln was profitable overall, bringing in $246 million in net income, or 75 cents a diluted share, up from $153 million, or 44 cents a diluted share, a year earlier. The Phoenix Cos. Inc. also reported a charge of $36.3 million in deferred-acquisition-cost-unlocking charges related to lapse rates and renewal premiums in its universal-life block, along with low interest rates. Deferred acquisition costs represent the deferred sales costs related to gaining new business. They can “unlock,” or change, to reflect updated expectations in light of different market assumptions. Manulife Financial Corp., the Canadian parent of John Hancock Financial Services Inc., docked a C$356 million ($352.9 million) charge in the third quarter related to falling interest rates. John Hancock Life Insurance Co. expects to raise prices on its no-lapse guaranteed UL in January. Manulife suffered a C$947 million ($938.8 million) loss in the third quarter, down from a loss of $172 million a year earlier. Protective Life Insurance Co., unlike its major competitors, reported an increase in third quarter pretax operating income in its life insurance operations to $30.9 million, from $26.5 million a year earlier, due largely to favorable mortality results. Protective Life reported $70.4 million in profit during the third quarter, up from $27.6 million in 2009.

'RECIPE FOR A PROBLEM'

“Low lapse rates and low interest rates are the recipe for a problem,” said Joel Levine, a senior vice president at Moody's Investors Service. “It's something we're aware of and to date, it hasn't been material, but we are watching it, because the longer the condition exists, the worse it gets.” Low interest rates hamper insurers because the companies make money from investment income and lately have faced lower reinvestment yields. In particular, insurance products that guarantee a certain interest rate are dragged down by poor investment returns. Universal life is particularly affected by low rates. Term life doesn't have much of an investment income component, while insurers can adjust dividends they pay out in whole life and participating whole-life products. Universal life, on the other hand, isn't as flexible. “Most life products are guaranteeing a 4% or better interest rate in the pricing of the product. Insurers have other ways to make that up, but this is an area where they anticipated a better spread,” said Thomas Rosendale, assistant vice president in the life-health ratings division at A.M. Best Cos. “Broadly speaking, with UL, it's difficult for life insurers to change their promise, so that basic concept has made UL among the most interest-rate-sensitive products the group sells,” said Randy Binner, an insurance analyst with FBR Capital Markets Corp. Universal life has been an “emerging issue” for the firm, particularly since August as the 10-year U.S. Treasury yield dipped, he said. Universal life is also a very popular product, as it can be used in pension maximization strategies and estate planning. Universal life sales accounted for 41% of the market share in terms of annualized premiums year-to-date in the second quarter, according to data from LIMRA. Term life and whole life made up 23% and 27%, respectively, of the market share in annualized premiums. Low rates are also hurting insurers as they search for ways to invest after the crisis. “A lot of companies went into significant cash positions post-crisis, and they're finding ways to redeploy it,” Mr. Rosendale said. “But right now, they're not finding a lot of investments.” But low interest rates aren't the only problem affecting insurers. Low lapse rates on legacy universal life with secondary or no-lapse guarantees have bitten carriers that sold a lot of that business — particularly in the 1990s.

UNLIKELY TO LINGER

Universal life policies with secondary guarantees have also been a big hit: Throughout the first half of 2010, UL with secondary, or no-lapse, guarantees —which ensure that the policyholder retains coverage even if the account value in the policy is depleted — made up about half of universal life annualized premiums, according to LIMRA. “Insurers expect a certain number of people to drop off the books, but that's part of the concern that came about with stranger-owned life insurance,” explained Mr. Rosendale. “One of the risks is that if this product was bought by an investor, then it's certain not to lapse.” He noted that companies have since taken measures to avoid the stranger-originated-life-insurance business, so some of those problems have been subsiding. So far, the damage does not seem to be material. Mr. Rosendale noted that many companies that write universal life with secondary guarantees have offloaded reserves related to that business into special internal vehicles, which give the main operating companies risk-based-capital relief. “Maybe you'll see noticeable [deferred acquisition costs] later next year for many companies, but we don't think it's material to capital and earnings levels,” said Mr. Binner. Low rates would have to continue over the next three years in order to affect earnings and capital, he added. “Given deflation fears and the purchase of more Treasury securities, it's possible [that the low-interest-rate environment could continue]; to me, it's extreme if the 10-year-Treasury yield stays low for that long,” Mr. Binner said. E-mail Darla Mercado at dmercado@investmentnews.com.