Changes in the Life Insurance Industry
I know I just sent you a newsletter a few days ago. I apologize if I’m sending you another one so soon but I believe this is too important not to share.
In the last two years, the life insurance industry has been completely turned on its head. With record low interest rates and changes in international accounting standards, insurance companies are being forced to change the way they do business.
Let me give you some background.
Ever since the financial crisis of 2008, the government has been lowering interest rates to help keep the economy going.
While lower interest rates are good for borrowers, it can be devastating to savers and investors who need higher interest rates to earn their income.
This has been the case for financial companies like insurance companies.
Insurance companies earn their income from several sources. Premiums and investment return from their reserves.
Premiums alone are not sufficient to provide earnings for the insurance companies, premiums are a factor of cost of insuring the risk and investment returns.
If the insurance companies charged premiums based on insuring the risk alone, they would have to substantially increase their premiums or one big loss could wipe out the whole company.
The concept of insurance is through something called "shared risk". Shared risk means that if there are 100 people and they all want to insure themselves for $50,000 each; the company charges everyone $500 a year for a total of $50,000. If there is one claim in that year, the company broke even (excluding expenses for simplification purposes).
If there is no claim in that year, then that $50,000 is kept in reserve and another $50,000 in premium is collected in the second year.
When claims are not paid in any time period, some of the money is kept as reserve. This reserve is not profit; it's merely kept to pay future claims. These reserves however are not held in a savings account, it is invested by the companies. Any interest or growth the companies earn in these reserves is kept as profits for the company.
For years, we have enjoyed low insurance rates because interest rates were steady at between 4 to 6%. Some investments in the stock market have returned 10% or more including some real estate investments. With these high returns, there is no need to charge higher and in most cases, premiums have gone lower to reflect the excess returns in these investments.
However, after the 2008 financial crisis, the central banks have kept interest rates very low with the Bank of Canada holding interest rates to 1%. The US Federal Reserve has interest rates set at 0.25%. The lowest it has ever been.
Because of these low interest rates, life insurance company's reserves are not earning enough to keep up with rising cost and to maintain certain guarantees promised in their policies.
Couple that with an aging population and longer life span but with more chronic illnesses, you come up with perfect recipe that will bring about drastic changes in the industry.
We are beginning to see it now. In the last 18 months, most, if not all life insurance companies have raised their rates by an average of 10 to 15% each time on their interest rate sensitive products like Universal Life policies, Long Term Care insurance and Critical Illness Insurance including Return of Premium riders on CI policies.
This month of June alone, I've seen two companies raise their rates and one company suspended sales of some of their products.
Yesterday, I got news that another company is going to stop selling their Guaranteed Minimum Withdrawal Benefit product which makes this the 2nd or 3rd company to do this in 2012.
Because the companies cannot make enough return on their investments to pay their expenses and have enough profit left over, they had to either increase their premiums or stop selling these products, otherwise, their financial stability may be affected.
Another factor that is affecting Canadian Insurance companies is the changes in global accounting rules.
The new accounting rule does not allow companies to smooth out their liabilities over time. Instead, they are required every quarter to report their liabilities “mark to market”. Meaning, they must report their liabilities at current prices. So if there is a quarter where interest rates go up 50 (0.50%) basis points, they have a great quarter, but if it fell 50 basis points (0.50%), it could be a horrible quarter and they may be forced to suddenly increase their capital requirements for their reserves. This makes it hard and very volatile to run a business that has liabilities in the book counted in decades.
Think of it this way, let’s say you buy a 10 unit apartment building for $5 million that you rent out and you have a mortgage on that building. Let’s assume that you put 20% down and your mortgage term is 25 years interest only loan and your tenants will be there for at least 10 years. In the old accounting rules, the banks will have on their books that you owe them $4 million in mortgage no matter what the market price of the building is today.
In the new accounting rule, if the market price of the building today is $5.2 million, you’re ok. But if the next quarter the market price of the building suddenly drops to $3.8 million, you’ll be forced to raise money to pay the bank $200,000 to bring the value of the loan back to $4 million because that’s how much they lent you.
In short, it’s like you have a potential margin call every quarter even though you know that you have no plans of selling the building until 20 years from now and you do not have to pay back the loan for 25 years.
Ok, the above example is not exactly how it’s done, but you get the general idea; long term obligation, but short term calculation of capital requirements.
The new accounting rules can suddenly make an A+ rated company become A- overnight.
If you’re an insurance company, your financial rating could change if the whole market suddenly changed directions which will affect your borrowing rate and capital requirements.
While this may sound scary, the fact is, Canadian Life Insurance companies still offers one the best products in the world. If you buy the right kind of insurance, your rates are guaranteed for life no matter what happens in the future.
So the only people who will be affected by the rate increase are those who are only buying the product now. Those who bought it before the increase are guaranteed that the rates they are paying now will stay the same for the life of the person.
For Critical Illness Insurance, as far as I know, Canada is the only country that offers "Return of Premium" benefit on death or surrender of the policy. This means that if you buy critical illness insurance with that benefit, if you never have a claim (meaning you stay healthy), you can get back all of the premiums you paid over the years without penalty or if you die but the cause of death was not payable according to the conditions of the policy, the whole premium you paid over the years are refunded back to your family.
This is in addition to guaranteed locked in premiums for the duration of the policy term and 22 to 24 covered illnesses.
In some parts of the world, they offer critical illness insurance that has no guaranteed rates. This means they can increase the rate at any time. They also only cover 10 to 15 illnesses as opposed to 22 to 24 in Canada.
I've heard some news that we may not see this type of product very long. We will either see Critical Illness coverage only with no option for Return of Premium benefit or critical illness may be gone from the market altogether.
Factors affecting these changes are interest rates and people living longer but are suffering more from critical and chronic illnesses. This goes back to the "shared risk" idea of insurance. If only a few people make claims, the company can continue selling the product as stands. But if more people make claims and if the investment returns are not making enough, then they risk depleting their reserves to pay future claims. They will either have to increase their premiums to build it back up or they will have to stop selling the product so as not to risk the existing reserve for future claims on current policy holders.
And then there is Long Term Care Insurance. Long Term Care insurance pays for your expenses in the event you need long term care when you can no longer do two of the five daily living activities like eating, dressing, bathing, toileting and moving without assistance.
As we are living longer, guess what happens when we get too old? We will eventually need assistance in one form or another. And the cost of this has skyrocketed.
In the US, some companies have gone out of this market completely.
From what I see, the insurance industry is going back to basics. In the 1980’s, it was all about Universal Life insurance due to the bull market in stocks and Whole Life Policies looked boring. Who would want a dividend of 6 to 8% when you can earn 15 to 20% in a Universal Life policy and it’s much cheaper too!
But now that we are in a global bear market, the Universal Life policies are suddenly unattractive while Whole Life Policies with guaranteed cash values and annuities are suddenly looking more attractive.
Luckily, Canadian Insurance companies cannot change the guarantees, bonuses or contractual obligations on existing or older Universal Life policies. So those who bought them before will see no changes to their policies.
In the last two years, the life insurance industry has been completely turned on its head. With record low interest rates and changes in international accounting standards, insurance companies are being forced to change the way they do business.
Let me give you some background.
Ever since the financial crisis of 2008, the government has been lowering interest rates to help keep the economy going.
While lower interest rates are good for borrowers, it can be devastating to savers and investors who need higher interest rates to earn their income.
This has been the case for financial companies like insurance companies.
Insurance companies earn their income from several sources. Premiums and investment return from their reserves.
Premiums alone are not sufficient to provide earnings for the insurance companies, premiums are a factor of cost of insuring the risk and investment returns.
If the insurance companies charged premiums based on insuring the risk alone, they would have to substantially increase their premiums or one big loss could wipe out the whole company.
The concept of insurance is through something called "shared risk". Shared risk means that if there are 100 people and they all want to insure themselves for $50,000 each; the company charges everyone $500 a year for a total of $50,000. If there is one claim in that year, the company broke even (excluding expenses for simplification purposes).
If there is no claim in that year, then that $50,000 is kept in reserve and another $50,000 in premium is collected in the second year.
When claims are not paid in any time period, some of the money is kept as reserve. This reserve is not profit; it's merely kept to pay future claims. These reserves however are not held in a savings account, it is invested by the companies. Any interest or growth the companies earn in these reserves is kept as profits for the company.
For years, we have enjoyed low insurance rates because interest rates were steady at between 4 to 6%. Some investments in the stock market have returned 10% or more including some real estate investments. With these high returns, there is no need to charge higher and in most cases, premiums have gone lower to reflect the excess returns in these investments.
However, after the 2008 financial crisis, the central banks have kept interest rates very low with the Bank of Canada holding interest rates to 1%. The US Federal Reserve has interest rates set at 0.25%. The lowest it has ever been.
Because of these low interest rates, life insurance company's reserves are not earning enough to keep up with rising cost and to maintain certain guarantees promised in their policies.
Couple that with an aging population and longer life span but with more chronic illnesses, you come up with perfect recipe that will bring about drastic changes in the industry.
We are beginning to see it now. In the last 18 months, most, if not all life insurance companies have raised their rates by an average of 10 to 15% each time on their interest rate sensitive products like Universal Life policies, Long Term Care insurance and Critical Illness Insurance including Return of Premium riders on CI policies.
This month of June alone, I've seen two companies raise their rates and one company suspended sales of some of their products.
Yesterday, I got news that another company is going to stop selling their Guaranteed Minimum Withdrawal Benefit product which makes this the 2nd or 3rd company to do this in 2012.
Because the companies cannot make enough return on their investments to pay their expenses and have enough profit left over, they had to either increase their premiums or stop selling these products, otherwise, their financial stability may be affected.
Another factor that is affecting Canadian Insurance companies is the changes in global accounting rules.
The new accounting rule does not allow companies to smooth out their liabilities over time. Instead, they are required every quarter to report their liabilities “mark to market”. Meaning, they must report their liabilities at current prices. So if there is a quarter where interest rates go up 50 (0.50%) basis points, they have a great quarter, but if it fell 50 basis points (0.50%), it could be a horrible quarter and they may be forced to suddenly increase their capital requirements for their reserves. This makes it hard and very volatile to run a business that has liabilities in the book counted in decades.
Think of it this way, let’s say you buy a 10 unit apartment building for $5 million that you rent out and you have a mortgage on that building. Let’s assume that you put 20% down and your mortgage term is 25 years interest only loan and your tenants will be there for at least 10 years. In the old accounting rules, the banks will have on their books that you owe them $4 million in mortgage no matter what the market price of the building is today.
In the new accounting rule, if the market price of the building today is $5.2 million, you’re ok. But if the next quarter the market price of the building suddenly drops to $3.8 million, you’ll be forced to raise money to pay the bank $200,000 to bring the value of the loan back to $4 million because that’s how much they lent you.
In short, it’s like you have a potential margin call every quarter even though you know that you have no plans of selling the building until 20 years from now and you do not have to pay back the loan for 25 years.
Ok, the above example is not exactly how it’s done, but you get the general idea; long term obligation, but short term calculation of capital requirements.
The new accounting rules can suddenly make an A+ rated company become A- overnight.
If you’re an insurance company, your financial rating could change if the whole market suddenly changed directions which will affect your borrowing rate and capital requirements.
While this may sound scary, the fact is, Canadian Life Insurance companies still offers one the best products in the world. If you buy the right kind of insurance, your rates are guaranteed for life no matter what happens in the future.
So the only people who will be affected by the rate increase are those who are only buying the product now. Those who bought it before the increase are guaranteed that the rates they are paying now will stay the same for the life of the person.
For Critical Illness Insurance, as far as I know, Canada is the only country that offers "Return of Premium" benefit on death or surrender of the policy. This means that if you buy critical illness insurance with that benefit, if you never have a claim (meaning you stay healthy), you can get back all of the premiums you paid over the years without penalty or if you die but the cause of death was not payable according to the conditions of the policy, the whole premium you paid over the years are refunded back to your family.
This is in addition to guaranteed locked in premiums for the duration of the policy term and 22 to 24 covered illnesses.
In some parts of the world, they offer critical illness insurance that has no guaranteed rates. This means they can increase the rate at any time. They also only cover 10 to 15 illnesses as opposed to 22 to 24 in Canada.
I've heard some news that we may not see this type of product very long. We will either see Critical Illness coverage only with no option for Return of Premium benefit or critical illness may be gone from the market altogether.
Factors affecting these changes are interest rates and people living longer but are suffering more from critical and chronic illnesses. This goes back to the "shared risk" idea of insurance. If only a few people make claims, the company can continue selling the product as stands. But if more people make claims and if the investment returns are not making enough, then they risk depleting their reserves to pay future claims. They will either have to increase their premiums to build it back up or they will have to stop selling the product so as not to risk the existing reserve for future claims on current policy holders.
And then there is Long Term Care Insurance. Long Term Care insurance pays for your expenses in the event you need long term care when you can no longer do two of the five daily living activities like eating, dressing, bathing, toileting and moving without assistance.
As we are living longer, guess what happens when we get too old? We will eventually need assistance in one form or another. And the cost of this has skyrocketed.
In the US, some companies have gone out of this market completely.
From what I see, the insurance industry is going back to basics. In the 1980’s, it was all about Universal Life insurance due to the bull market in stocks and Whole Life Policies looked boring. Who would want a dividend of 6 to 8% when you can earn 15 to 20% in a Universal Life policy and it’s much cheaper too!
But now that we are in a global bear market, the Universal Life policies are suddenly unattractive while Whole Life Policies with guaranteed cash values and annuities are suddenly looking more attractive.
Luckily, Canadian Insurance companies cannot change the guarantees, bonuses or contractual obligations on existing or older Universal Life policies. So those who bought them before will see no changes to their policies.
Comments
Post a Comment