The stock market has seen some sharp reversals in recent weeks due to an expectation that interest r...
The stock market has seen some sharp reversals in recent weeks due to an expectation that interest rates will rise an expectation that the Bank of England matched when it raised rates by 0.25% in early September. Because stock markets fall and the cost of borrowing goes up when interest rates rise, it is reported as bad news, while decreases are presented as the opposite.
There is the odd mention of how investors reliant on interest for their incomes most typically retired people are adversely affected, but as more journalists have mortgage rather than pension problems, it is perhaps understandable why moves in rates are interpreted the way they are.
However, it is not just investors getting used to lower returns that suffer when interest rates fall. Holders, and prospective holders, of policies offering to replace income lost through disability or illness are also affected.
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Income protection.
Income protection insurance is the prime example. It offers an income in the event of a policyholder being too ill to work. That income could begin within months of the cover commencing for example, if the policyholder is unfortunate enough to suffer a disabling accident and continue for a period of months or years, even up to the policyholder's retirement age.
However, the life office providing the cover through its underwriting process can have no idea of when claims might begin, hardly more of an idea when they might end and how long the period of time might be between the two events. But it must make a sensible estimate of the capital value of its prospective payments so that it can keep track of its liabilities. In effect, it is trying to calculate the cost of providing an annuity for an indeterminate length of time with effect from an unspecified date. This disability annuity, although more complicated to cost for than normal life annuities, has exactly the same problems attached when interest rates fall.
Prudently (and because they are required to), life offices keep reserves back from the premiums they collect for IPI to cover future claims. To make the most of these reserves they are generally invested in assets that are designed to match, as closely as possible, the need to provide a guaranteed benefit over a long term typically gilts, corporate bonds and the like. Knowing that they will achieve some measure of growth in their reserves through the accrual of interest on them, the insurers are able to factor this into the rates of premium they will charge for their IPI policies.
If they assume a high rate of interest will be earned they can reduce their premiums, but insurance companies are just as prone to the effects of interest rate fluctuations as the rest of us. If interest rates fall, there should be a corresponding increase in the amount of premiums they need to collect to maintain the same benefits under an IPI policy.
Of course, insurance policies in general, including IPI, do not have premiums that change every time there is a move in interest rates. Some do not change at all because the insurance company has guaranteed they will not. Insurers have to take a view about the general level of interest rates in the long term and think about how frequently they ought to reconsider the validity of this view rather than one based on the exact interest rate now. The question is, are they getting it right.
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History.
At the start of the 1970s, bank base rates in the UK were in single figures. However, the fall in the value of the pound, escalating wage and price inflation and a rapid increase in the supply of credit were all leading to inflation and putting pressure on interest rates. By the end of 1973, rates were up around the 13% level. Apart from occasional and short-lived periods, interest rates remained in double figures until the beginning of the 1990s.
In many ways, these were years of plenty for life offices. For almost the entire period, house prices were leaping ahead, fuelled by what many thought (incorrectly, as it turned out) to be insatiable demand. Largely on the back of this, mortgage-related policies sold by the bucket load and institutions such as banks, building societies and estate agents all jumped onto the life assurance bandwagon. Premiums were driven down by the need to compete and could afford to be because the high rates of interest to be earned on reserves would compensate.
Towards the end of the 1980s, when the boom ended (as it had to eventually), spending on houses and in general collapsed. This brought some benefits. Inflation was finally brought under control. Interest rates could come down. At the end of 1992 bank base rates were around 7.
Since then, they have stayed in single figures. The incoming Labour Government passed responsibility for setting interest rates to the Bank of England and although a series of increases followed, they were all fractions of a percent, as opposed to the multiples they had been in the 1980s. They have since come back down to their present level around 5.
Even the recent rise is only a tiny movement relative to the leaps of 10 years ago, and few commentators are predicting this is but the first of a long string of increases. To put it another way, we have been in a low-inflation, low -interest rate environment for most of the 1990s and things look set to stay that way, especially as the Government wants to keep open the option of joining the euro, whichever way its decision ultimately goes.
As organisations that have to operate over the long term, it is understandable that life companies have delayed adjusting their reserving assumptions. They had to be sure low interest rates were here to stay for the foreseeable future before they could factor a new level of interest rates into their premium calculations. Now, however, there are growing signs that they may have left it late and are having to take some hurried remedial action.
The potential problems of endowment policies not generating sufficient returns to repay their associated mortgages and annuities with guaranteed levels that were modest by historic standards, but are now on the generous side, are well known. Less publicised is the impact on IPI policies as described earlier.
In the insurance companies' favour is their generally conservative nature. Consequently, even when interest rates were 15% and above, they would not have based their IPI reserving, and therefore their premiums, on the assumption that they would remain at these levels. Working against them, the fall was greater and has been sustained for longer than they could have reasonably expected. The net result is that their assumptions about the rates of interest their reserves will earn have to be revised downwards. The amount will vary from one office to another.
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Impact on premiums.
Let us say they have decided that their assumed rate of return on their reserves is 2% too high. What impact will this have on their IPI premiums? Of course, there is no hard and fast answer, partly because there is a degree of subjectivity involved and partly because there are so many possible variables. What is beyond argument is that the greatest impact is on the youngest ages due to the greater compounding effect of the change over the long periods that their contracts will run. For a 30 year old looking for a policy to run to his 65th birthday with 3% escalation and a deferred period of 26 weeks, the risk premiums (that is, excluding expenses, profit margin and so on) have to rise by about 15% to provide the same benefit. For a 50 year old, the increase is a more modest, but still substantial 10.
The deferred period selected will also have an impact, but only a marginal one because the variations in the lengths of time involved are much shorter.
Of course, it is not just interest rates that affect the level of IPI premium rates. The part of the premium covering the insurer's expenses, including profit, is not directly affected. Unfortunately, the other prime driver of IPI premiums, the general experience of claims as made up by their frequency, level and duration, has also been worsening. The message is clear rates for income protection insurance have got to increase.
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Reviewable policies.
Advisers who have clients with reviewable policies should be aware that increases at future premium review dates are on the cards. The cost of new guaranteed contracts ought to increase as well, and generally by greater amounts than apply to reviewable contracts because there will be no subsequent opportunity to adjust them.
Clients with existing guaranteed policies are sitting pretty, assuming they have not paid over the odds to get the guarantee, but their insurers may not feel quite so sanguine. Unless they have already taken care to match an asset carrying an appropriate high rate of guaranteed interest to their potential liability, their profits will slump or even turn into losses.
On the other hand, this is an extremely competitive market. It is much easier for one office to follow another's increase than to put up its own rates unilaterally and hope others will follow. However, the downside of a short-term sacrifice of new business sales choice must be weighed against the alternative damage done to the long-term profitability, and therefore viability, of their IPI business.
Peter Fenner is marketing analyst at ERC Frankona.
