Damn confused

[CowboyGuy]

What impact does interest rate have on a life insurance company?

I read in the book "Life Insurance Products & Finance" that

"a rise in interest rates can cause losses for the company"

On the other hand, we all know when interest rates decrease, company's credit spread on investment-oriented products will decrease, thus reducing company's earnings.

I'm confused what impact does a rise and fall in interest rates cause on a company and what's the rationale behind it?

[Abused Student]

You have the investment stuff. There is also pricing. Products are priced assuming a certain discount factor if their discount factor is too low the price will be too high and they will lose out on sales. The type of product comes into play as well.

[CowboyGuy]

You have the investment stuff. There is also pricing. Products are priced assuming a certain discount factor if their discount factor is too low the price will be too high and they will lose out on sales. The type of product comes into play as well.

So we can't reach to an answer on what overall (net) impact will a rise or fall in interest rates have on company's earnings/balance sheet?

[CowboyGuy]

Also, the value of bonds the company holds changes with interest rates.

Is there an intuitive and simply way to explain how this works?

Some books I've read simply illustrate "a rise in interest rates can incur losses for the company". Is this a correct statement in all scenarios?

[Double High C]

Hey Cowboy:

What do you think happens if interest rates severely spike upward, and a very high pct of your policyholders all want to surrender their policies?

[CowboyGuy]

Hey Cowboy:

What do you think happens if interest rates severely spike upward, and a very high pct of your policyholders all want to surrender their policies?

This is disintermediation risk.

So are you saying a reasonable rise in interest rates is good for the company while a severe spike upward is bad?

[CowboyGuy]

Hey Cowboy:

What do you think happens if interest rates severely spike upward, and a very high pct of your policyholders all want to surrender their policies?

How about this(?):

When interest rates rise, there are two consequences:

1) the value of bonds decrease (reducing company's asset values)
2) policyholders surrender their policies (reducing earnings)

However, when interest rates decrease, there is one consequence:

3) company is not able to earn its spread on investment products

Since 1+2 > 3, a company generally loses money when interest rates rise.

[Steve Grondin]

It's not that simple. If a company has a good match between liability cash flows and asset cash flows it is relatively immunized to interest rate changes. So the losses on the assets would be on a mark-to-market basis only. Also some GAAP bases use current interest rates for discounting, so you may see some decrease in the liabilities as well.

There can also be capital relief due to interest rate increases (C3P2 I'm looking at you).

But as the brassy one mentioned, a sharp spike in interest rates can change the liability cash flows that might have been previously well matched to the asset portfolio, as well as extension risk in the assets with flexible cash flows.

[rekrap]

The recent Product Matters (Issue 83, June 2012) has a relevant article on pages 10-16 (especially the pg13 straddle graph).

[Double High C]

Good answer, Mr. Parker (albeit one to an intentionally obtuse question).

[urysohn]

Also, the value of bonds the company holds changes with interest rates.


This. A rise in interest rates might lead to an increase in surrenders (as policyholders flock to more favorable products or investments).

Assets are sold at market value. Life insurance liabilities are marked at book value for most US carriers. So rising rates will cause assets to be sold at below book, while liabilities are released at book.