Turbulent economy, low interest rates have everyone feeling pinch

The average investor isn't the only one feeling the pinch of stock market volatility and low interest rates these days.

Chances are your friendly neighbourhood insurance giant is experiencing its own form of financial angina as its margins are squeezed by poor market conditions.

By nature, insurers are conservative creatures. They need to be in order to survive. For years, they've collected policyholder premiums and invested mostly in bonds and mortgages, which are tied to the economy and interest rates set by central banks. They have made a nice living, keeping their customers and shareholders happy. But these days, interest rates are at historic lows, so making a buck and keeping up contractual obligations -- paying a benefit when a policyholder dies, for example -- aren't as easy as they used to be.

And if they're feeling the pinch, so too are their customers, says industry expert Moshe Milevsky, professor of finance at York University's Schulich School of Business.

"The fact that insurance companies are now passing the costs on to the consumer means that they now realize that this (economic uncertainty) will go on for a while," says Milevsky, also the director of the Individual Finance and Insurance Decisions Centre in Toronto.

While consumers are likely facing premium increases for insurance of all kinds now and in the foreseeable future, those feeling the most pain are people either shopping for life insurance or existing policyholders of long-term plans.

In particular, policyholders of whole-life insurance plans may experience the most severe premium-increase shocks.

This might come as a surprise to many policyholders who had assumed their premiums were fixed and wouldn't increase, says Ron Sanderson, director for policyholder taxation and pensions for the Canadian Life and Health Insurance Association.

"The term 'whole life' is not entirely accurate," says Sanderson, the spokesman for the association representing the interests of the industry. "The coverage is designed to protect you for the rest of your life, but there really is a spectrum of product out there."

Some policies have adjustable premiums that can be increased after certain periods, such as 10 years. The premiums for these policies are interest-rate sensitive, Sanderson says, so policies that are more than 10 years old could see premium hikes because interest rates are lower today than a decade ago.

Other whole-life policies do have fixed rates, but a professor of actuary science at the Asper School of Business at the University of Manitoba says policyholders of these plans could still see increases above what they've been used to paying in the past.

Professor Sam Cox says these plans -- called participating whole-life insurance -- have fixed rates that are often reduced as long as the company earns a good return from investing the premiums.

"The company makes profits and it shares some of those with the policyholders," he says.

Profits are paid out as a dividend to policyholders and in many cases, the dividend is used to reduce the fixed-premium cost.

Cox says policyholders might assume they are paying a lower fixed rate because the dividend payment has remained stable for so long and has made the premium less costly.

But it's likely that when they signed up, the contract included a section stating the dividend was not guaranteed.

"It's usually pretty plain that the dividend is not guaranteed," Cox says.

Confusion, however, might arise when policyholders were originally presented with documentation that illustrated the relationship between premiums, interest rates, company profits and dividends.

"When you're buying a product like this, industry practice is to provide in the documentation an illustration of what the savings value and the premiums are anticipated to be, and that will generally be based upon two, sometimes three investment scenarios," Sanderson says.

One scenario might show the current long-term expectations of the day, based on the yield of five- or 10-year Government of Canada bonds -- the benchmark for a risk-free return. This would form the basis of the calculation for the fixed premium the policyholder would pay.

The second scenario might be a rainbows-and-lollipops illustration with high yields.

"He or she might be shown an optimistic scenario where rates went to 14 per cent," Sanderson says. It would also show how a dividend would increase in relation to these higher returns.

The other scenario would show the effect of decreasing yields in a low-interest-rate climate.

The problem, insurers and policyholders are realizing today, is that when many of these policies were sold a decade ago, the illustrated "bad scenarios" weren't bad enough. By today's standards, they look pretty optimistic.

"The rates that they (insurers) are now getting on those long-term investments are nowhere near what they projected," Milevsky says.

"If you had told them 20 years ago that in 2012 they'd be getting two per cent on their money, they wouldn't have believed you."

The fact is, no actuary -- the mathematical wizard behind calculating rates -- could have predicted the global banking system would be brought to its knees in 2008.

"Black swans aren't as rare as we were led to believe," Sanderson says.

And although insurers may have been able to absorb one crushing blow to the balance sheet, they're now faced with low interest rates for a very long time. And low rates equate to low yields on investments, leading to fewer profits, meaning the dividends that subsidize premiums are smaller.

Basically, the model of investing premiums for easy, risk-free returns doesn't work as well as it once did.

"As we've seen with sovereign debt in Europe, the notion of a risk-free return is off the table these days," Sanderson says.

But insurers also have the regulator to satisfy. The Office of the Superintendent of Financial Institutions (OSFI) monitors insurers' capital requirements, and if it appears there's even a hint they may not have enough capital to meet their obligations, they are required to find the money.

"It doesn't mean the insurer's insolvent," Sanderson says. "It just means the regulators say pony up a little bit more cash in order to make sure that the company will, in fact, have the cash available to pay those claims when they come."

Because insurers are limited in the amount of investment risk they can take on to make up for lower returns on traditional investments such as government bonds, their only other option is raising premiums.

It's a tough pill to swallow for insurers and policyholders alike.

Yet Cox says consumers with existing policies should think carefully before opting out of their policy and taking the surrender value. It may be hard to find a better deal in the marketplace today than the policy they already own.

"By now, most of the big expenses have already been paid on the existing policy," Cox says. "If you still need life insurance, you couldn't easily replace it."

giganticsmile@gmail.com

Republished from the Winnipeg Free Press print edition January 28, 2012 B10