I often field questions about what financial metrics I hold most important when analyzing life insurance companies. While my answer can be a tad complex, I do have a short list of key metrics on which I place considerable weight.
The singularly most important metric of them all is investment income compared to policy obligations. I hold this key piece of financial data so important because it deals with one of the biggest drivers of life insurer profitability.
So, today we'll talk about what specifically this is, and look at the most recent analysis performed on the trend of this key metric among major mutual life insurers.
Identifying Life Insurer Investment Income
Investment income for a life insurance company is very straightforward. It's the income generated by the assets held in the insurer's General Account.
You should understand that this does not include the capital gains recognized by the life insurer through the sale of assets.
Identifying Life Insurer Policy Obligations
Obligations are the features that life insurer make available to policyholders through the myriad of insurance contracts they issue. These obligations traditionally take the shape of accumulated values held inside the policy.
The obligations also include the reserving requirements the insurer must hold in order to meet regulatory guidelines to offer contractual benefits like a death benefit or a disability waiver of premiums.
Why Worry about Investment Income Compared to Obligations?
One of, if not the, biggest drivers of profits at a life insurance company is the difference between what a life insurance company promises its policyholders and what it can generate in terms of income from the premiums it collects.
Like all financial intermediaries, value generated over and above the inducements given to those who place their money with you, become a key focus for operational profitability.
So for example, if a life insurer promises a 4% rate of return to policyholders on a life insurance contract, but can use the premiums collected to create an 8% return with the money, the life insurer has considerable profits. It's obligated to pay the policyholder 4% on his/her money. At the same time, the life insurer double that promised amount. This leaves plenty of money for the life insurer to pay the policyholder his/her 4% and have money left over.
I assure you this is an extreme example. It's uncommon for a life insurer to always generate double the earnings on assets that it promises to pay policyholders.
If you've spent any time digging around for information on the life insurance industry, there's a good chance you happened upon some information stating that low interest rates cause frustration for life insurance companies.
This is because lower interest rates reduce the gap between what insurers promise(d) policyholders and what they can achieve as a return on the premiums collected from policyholders.
It should come as little to no surprise to hear that some life insurance companies manage this gap and falling interest rates better than others. Better management of this gap (i.e. the ability to keep it larger) leads to better profitability. We care a lot about profitability when discussing mutual life insurers because that profitability feeds the dividend. The dividend is the greatest driver of cash value benefits of a whole life insurance policy. It can also drive substantial benefits for some annuity contracts issued by mutual life insurers.
So when I'm looking at a life insurer and reviewing the company's annual or quarterly financial data, I pay special attention to its investment income and how it compares to policyholder obligations. I also spend considerable time reviewing how the two change relative to one another over time.
Investment Income to Policy Obligations Five Year Study
I compiled data on investment income and policy obligations at 11 major mutual life insurers in the United States. This data spans the last five years. This data comes from the statutory financial filings all insurers must prepare per NAIC guidelines.
I used the annual data to calculate the average rate of change over the five years period for all 11 life insurance companies. I calculated both the average change in annual investment income and annual policy obligations.
Here is the data:
|Company||Investment Income Growth||Policy Obligation Growth|
|American United Life||3.38%||5.40%|
|New York Life||6.13%||3.91%|
|Saving Bank Life||1.06%||1.51%|
For all but two of the life insurers analyzed (New York Life and PacLife) obligations grew faster year-over-year than investment income. This is evidence of the frustration voiced by life insurers. Obligations grow faster than investment income, due largely to lower interest rates, which leads to compress profits.
Some insurers experienced significantly larger growth in obligations than investment income.
Guardian and Ohio National experienced the greatest divergence in outpaced obligation growth versus investment income growth. Northwestern Mutual and Ameritas also experienced growth in obligations that were quite ahead of investment income growth.
Declining Income Growth and Increased Obligations: Bad Sign for the Industry?
Ideally, the trend would be in the reverse. We'd much rather see insurers growing investment income at a pace larger than the growth in policy obligations. But continued low interest rates place a significant damper on the amount of investment income life insurers generate.
This trend is not great, but it's also not a harbinger of insolvency. It does point to likely continued lower dividends paid to participating whole life policyholders.
It also very likely means less benefit rich policy offerings. Life insurers will build expectations on profitability for policies given current economic conditions. This leads to products promising fewer benefits to policyholders because the expectations on investment yield is lower.
More to the Story
While many insurers struggle with compression of profits as obligations grow faster than investment income, many life insurers due generate profits from other sources.
Life insurers also have underwriting profits. This is the income generated when fewer policyholders die than planned.
Several of these insurers also own tangential businesses that produce additional profitability. There is no exact model for this. But some insurers own investment management firms. Other owns–or have partial ownership–in business completely unrelated to the financial services industry.
In all cases, these additional sources of income can help make up some of the compression on profitability realized from declining investment income.