FDLIC Corporate Officers blog about current issues in the preneed industry and in funeral service, providing insight, commentary, and news updates.
Where Has All the Interest Gone?
Tuesday, August 17, 2010
There are a lot of people and businesses in this country that pretty much live and die based on the level of interest rates. Many retirees have seen their incomes cut drastically the last couple of years as CD rates plunged below 1%. Banks, insurance companies and other financial institutions live and die by interest rates also. More specifically, by the spread between what they earn on their investments and what they pay to their depositors or policyholders. Banks have done a pretty good job of managing the spread; that's why they are paying such low rates on deposits, and have been recording excellent profits. It's a little more complicated with insurance companies because the investments and payout liabilities are longer term and more complicated.
In the preneed insurance industry, growth rates being paid have been generally dropping over the past few years (though not at FDLIC) in response to the interest rate environment. Preneed insurance, on the average, tends to stay on the books for 8-10 years. Half the business is gone in 6-7 years. As such, preneed insurance companies can't just invest all their cash flow in 30-year bonds because they need the money sooner than that. We have to invest all along the curve to try to have an average investment cash flow life of 8-10 years. That means a lot of it has to be invested shorter than 10 years. Let's look at what has happened to those investment rates over the past few years. One reasonable proxy for what preneed insurance companies invest in is 10-year A-rated Industrial bonds. Shown below is the average yield on those 10-year A-rated bonds as of the end of July for the years listed.
2007 - 5.72%
2008 - 5.73%
2009 - 4.93%
2010 - 4.15%
Wow! Over a three year period, these bond yields have dropped 1.57%. Another way of looking at it is yield has fallen by 27% from what it was in July, 2007. It's even worse on 5-year A-rated bonds. Those yields have fallen by 2.75%, cutting yields in half! Needless to say, interest rates have crashed over the past three years, causing bond prices to skyrocket (bond prices move opposite to yield).
There are those who say we are in the midst of a bond market bubble, much like the stock market bubble that ended in 2000 and the housing market bubble that peaked in 2007. It's impossible to say because one criterion for a bubble is that it is invisible to those who are inside it. Very few predicted the stock market crash of 2000-2002 or the recent housing market crash. Very few are predicting a bond market crash currently.
All of this uncertainty and volatility make it very difficult for preneed insurance companies to accurately determine in advance the growth rates they should pay, since bond yields may very well be vastly different a year from now, higher or lower. I guess it's the Chinese curse of living in interesting times.