Rotten Insurer Guarantees?

If you’ve bought an insurance product with a guaranteed return, you may be in for a nasty surprise down the road. As you already know, life insurance and annuity products sell well, in no small part due to the guarantees that are often associated with those products.

Although those insurance guarantees are relatively costly, they play well to the investor’s desire for an asymmetric risk/reward profile. What on earth do I mean by that? Well, studies by Daniel Kahneman, the Nobel Laureate, and other behavioral scientists have taught us that for every unit of loss in a market cycle, investors expect two or more units of gain.

Well, of course history had taught us that this is not possible. Through financial engineering, insurance companies have rejiggered the risk/reward profile and promised no losses and a taste of the upside. We already know these are expensive guarantees, but the question today is, how can insurers guarantee returns greater than the underlying assets permit?

Here’s what I mean by this. According to the most recent edition of The Economist, 80% of insurer assets are invested in fixed income investments. Let’s take 4% guarantees, for example, that were protected with bonds that are currently maturing and are being replaced with new bonds at much lower yields. This is not sustainable.

These guarantees are not sustainable if interest rates stay where they are today. In fact, ratings agency Fitch had warned that some insurers are taking on too much risk in search of this yield. Moody’s, another ratings agency, has stated a fear that sustained low interest rates will over time drive a number of insurers into insolvency.

The insurer savings business model relies on these guarantees. It was a model, and still is the place investors look to, for this desired asymmetric risk/reward profile. This model thrives in an environment where short-term yields are greater than 2% and government bonds are paying greater than 4% with no real default risk.

Today’s zero interest rate policy that exists at the short end of the spectrum in 60% of the world’s nations has created an existential threat to this model. In fact, the National Association of Insurance Commissioners has identified low interest rates as a major threat for life companies given their rate-sensitive products and investments.

The challenge for investors everywhere is to really understand that, fundamentally, risk mitigation costs money. There’s no free lunch here, and asymmetrical rewards are not reasonable, and they are certainly not without expense. What really is the best-performing replacement for this type of product? Simply put, it is to allocate assets with a five-year rolling window perspective. Why? Since 1929, a 65/35 asset allocation has never had a negative five-year rolling return.

They’ve met that guarantee; ergo, at our firm, the five-year mantra. What do we mean by the five-year mantra? We mean that if you have financial needs — cash needs — within the next five years to be funded from your portfolio, those assets should be isolated so that the core asset allocation can work its five-year rolling magic. What have we got here? We’ve got a model that allows us to achieve the same goals with less cost and greater expected returns.

We wish you the best of investing success. Thank you.

Sources:

Holsboer, Jan. “The Impact of Low Interest Rates on Insurers.” The Geneva Papers on Risk and Insurance. https://www.genevaassociation.org/media/235644/ga2000_gp25(1)_holsboer.pdf (accessed March 1, 2016).

“Low Interest Rates.” National Association of Insurance Commissioners. http://www.naic.org/cipr_topics/topic_low_interest_rates.htm (accessed March 1, 2016).

“The Lowdown.” The Economist. http://www.economist.com/news/finance-and-economics/21693247-insurers-regret-their-guarantees-lowdown (accessed March 1, 2016).