Life insurance companies are big players in the fixed-income markets, normally buying and holding a lot of longer-term bonds because they have long-dated liabilities.
A $100,000 life insurance policy on a 35-year-old man, for example, is a liability that likely won’t have to be paid for 30 years or so.
How does an insurance company hedge that to ensure the money will be available? It buys bonds with lengthy redemption periods, such as the 30-year bond. The company sells an insurance policy to an individual, invests and grows that money to build a capital base so when the individual passes away, the proceeds of the life insurance policy is there for the beneficiaries.
“Because of their liability structure, because they’re willing to essentially pay someone a future stream of income, insurance companies are very big players in the bond market,” said Mitchell Stapley, Fifth Third Investment Advisors’ chief fixed-income officer.
“They look to find securities that provide them with a stream of income to match the liability they have. With any luck, they get a higher yielding stream of income than what they’re going to pay out.”
Life insurance companies tend to have portfolios of longer duration, while property and casualty insurance companies, on the other hand, might buy a lot of shorter-term bonds. Traditionally, both have been players in the high-yield junk bond market, as well.
Stapley explained that many insurance companies suffered last year with the collapse of Enron, WorldCom and other corporate giants because they held millions of dollars of corporate bonds in those corporations.
So the money to pay off policyholders or beneficiaries, he explained, had to come out of the surpluses in their balance sheets.
“Insurance companies have had a rough go of it because of the bond market and what big players they were in the high-yield junk bond market over the last couple of years,” he said.
“That’s where you’ve seen their earnings be under some pressure.”
Although their portfolios are normally tilted towards bonds, Stapley said they own stocks in their investment portfolios, too, and the stock market hasn’t been doing well, either.
“You hear a lot of talk on the street about a lot of insurance companies going to much higher-grade portfolios than they’ve used in the past,” he said.
“This last year, there has been a real change of an almost religious proportion among insurance companies in terms of upgrading the quality of portfolios.
“That might mean they’re not selling out of all their corporate bonds — their Ford and GMAC and Citibank and Wells Fargo paper — and buying treasuries, but there has probably been a move out of the more speculative low investment grade, junk bond names into the investment grade market. And they’re much more diversified.”
In early May the Federal Reserve Bank’s Open Market Committee said the risks of the economy were balanced between too much growth and too little growth, and that the real risk was a renewed downturn in prices, i.e. deflation.
By alluding to the risks of deflation, Stapley said, the Fed caused a huge rally in the bond market, suggesting to investors that buying bonds was the right move because interest rates were headed lower.
But bond prices fell sharply June 25 after the Federal Reserve cut short-term interest rates by a quarter percentage point to 1 percent. There’s a lot of leverage and speculation going on in the bond market right now, Stapley said.
From an overall business perspective, the pricing power of insurance companies has picked up, he said.
“They’re getting some decent earnings growth because premiums have been going up and they’ve been able to stick with them.”
This year, junk bonds have had a tremendous period of return and the low interest rate environment of the past year has been a boon to insurance companies, as well, since the price of bonds rise when interest rates fall.
Stapley said it has been an especially prosperous period for insurance companies that have had very high-quality portfolios. “Their earnings have been very good,” he noted.
“In terms of their bond portfolio — with the decline in interest rates and improvement in the junk bond market — most insurance companies have seen some positive returns coming into their portfolios over the first five months of the year.”
The concern now is that if interest rates were to go up sharply from here, the price of bonds would go down.
Traditionally, insurance companies are heavily into investment-grade corporate bonds and have fairly good-sized positions in junk bonds, as well.
Because of their additional yield, Stapley said, those fixed-income instruments would do better than, say, treasury securities in a rising interest rate environment.
“Even if interest goes up, the chance of a single-name credit blow-up hurting their portfolio has probably been lessened by this new focus on diversification and higher quality.”