While Europeans leave the Euro and Euro bonds in droves for the safety and serenity of U.S. Treasuries, forcing the interest rates here in the U.S. on the 10 year to near record lows, currently at 1.45%, many, including myself, talk about the coming Treasury bubble once interest rates reverse course. But it's not just the U.S. Treasury that is worried about higher rates, it's the banking and insurance industries too, as higher rates would decimate both industries. This article will explain just what trouble they are going to be facing in the months and years ahead.
What caused me to delve into this analysis now was a recent article that Mish Shedlock wrote where he made the following statement;
Banks are not lending now for three reasons
- Banks are capital impaired
- Banks are worried about being repaid
- The relatively small pool of credit-worthy borrowers who banks would lend to right now, do not want credit
I have written many articles on the issues with the nations top banks, and haven't written on one other issue these and all other banks have, a similar issue the insurance industry is facing in the near future. First though, let me address one more reason banks aren't lending which I believe Mish left out.
Reason 4 Why Banks Are Not Lending Now
4. Bank owners don't want to lock in a low interest rate for 30 years
If you own a bank, would you want to lock in these low rates for 30 years via extending a mortgage? I would think not.
I remember in the mid 80's my clients bragging about locking in their 5% mortgage rate. A decade or so from now, I imagine getting the same response from those who lock in today's low rates. This doesn't mean that real estate is a bargain at today's prices, but these rates sure make it attractive for many who just want a tax write off and are tired of paying someone else's mortgage to think about investing in real estate. These issues I have addressed here and here.
Bank Owners Know They Are in Trouble as They Know Higher Rates Are the Future
What would higher interest rates do to the banks that make loans today? Will this increase or decrease those approved for loans?
The answer is an obvious, decrease. Higher rates would kill an already defeated loan industry. How is the loan industry already defeated? They just lost 21% of their ability to loan because Wells Fargo, who just settled a discrimination lawsuit for $175 million, has ceased doing loans. If those who were allegedly discriminated against before couldn't get a loan, try and get one now.
At present, loan applications for FHA fell by 20.7% over last month and refi applications fell 44%. If no one is borrowing at today's low rates, will a zero rate induce purchases? Will banks loan? If you owned a bank, would you? Seriously, where is the profit to be gained?
Is it any wonder that the nations top banks and other financial companies are playing the derivatives market to try and make a buck? From the looks of it, they suck at it too. Just look at the multi-billion loss (over $5 billion) by J.P. Morgan recently as well as the bankruptcy of MF Global. They made bad bets and lost. Who's next?
The Fed has to keep rates low as long as possible, and bank owners and managers are doing all they can to try and pay the bills and eek out a profit. If that means taking on more risk, then of course they will do that because they know Uncle Sam will be there to bail them out at taxpayer expense...."to save the system." See TARP.
Which brings us to an industry that has flown under the radar of most....until now.
The Insurance Industry Problems Coming To Surface
Many may not realize this, but for years insurance companies have guaranteed 3%, 4% or more on their annuity and life insurance contracts. Annuities are the type of product that pay a stated amount of interest for a specified period of time, but have a guarantee built into them that states the interest rate won't fall below a certain percentage. While there are various types of annuities, the majority of them sold before the hybrid or variable annuities surfaced, were what were called "fixed" annuities. The same goes for the stated rate of interest guaranteed in life insurance contracts called Universal Life.
The problem for these types of products is interest rates have fallen below the guaranteed rates.
How Does An Insurance Company Investment Manager Invest Their Assets?
Insurance companies that sell annuities and life insurance are long term oriented in nature. They plan for decades ahead to make sure they have the funds available to meet the mortality of their clients in the future. In other words, they are counted on to be there when the money is needed.
But insurance companies have to have good investment management to plan ahead for these future claims on their assets. In the meantime, they have to pay their salesmen, employees and try to eek out a profit for their stock holders if a stock company, or dividend if they are a mutual company. So the overall rate of return on investments is something that a policy holder of that company would want to analyze.
I know for decades, the insurance companies guaranteed 3% (or more) on their life insurance and annuity products. Some of these insurance companies invested in longer term bonds years ago that have allowed them to keep paying the higher rates to their clients through today. But how are these insurance companies investing today? Are their portfolio managers locking in these low 5 and 10 year rates? Longer? What about those companies that didn't lock in the higher rates years ago, but promised their clients 3% or more?
"If" we did have a continuance of this low interest rate environment, how can many of these companies survive?....especially when the majority are limited in scope of investment as most insurance companies are investing in bonds...(they usually invest very little in stocks, most under a 5% allocation).
Let's take a look at some of the nations top insurance companies and see what trends are developing. The following chart shows the ratings of various companies using two of the following ratings companies, A.M. Best and Weiss.
A.M. Best is the most recognized name of ratings company for insurers and they provide a financial and operating performance rating. Weiss Ratings is known as a stickler that many in the insurance field don't like because of their perceived bias. Weiss and other ratings agencies are explained below;
- Standard & Poor's provides financial strength ratings for those insurers who request a rating. S&P also provides financial strength ratings from public information for other insurers.
- Moody's and Fitch provide ratings for those insurers who request a rating. Therefore, ratings from these two services are not available for all insurance companies.
- Weiss Ratings provides safety ratings on more than 1,700 insurance companies.
- The Comdex Ranking
The chart analyzes what percentage of assets each of these insurers have invested in bonds and stocks, what the yield has been on assets for the last 5 and 1 years, as well as the return on investments.
As you can see by the above chart, the current investment yield is lower than the 5 year average for all but one of these companies (Allianz who has had a higher percentage in bonds than the other companies). With the investment yield falling and return on equity even turning negative in two cases above, insurance companies in general will be struggling to just make ends meet in the months and years to come. Once interest rates do move higher, and depending on the length of time each of these companies has invested their bond portfolio will dictate possible future issues. Did they lock in today's 1.45% 10 year Treasury, guaranteeing them a rather lousy return compared to historic returns moving forward? Are they buying more short term bond maturities so they don't get stuck with the lower rates when interest rates turn higher? Or are they taking on more risk in other areas to make up for these interest rate declines. What if interest rates stay lower ala Japan for 10 more years? (I am not in this latter camp, but many thought Japan, the world leader in Debt to GDP ratio, wouldn't be able to handle this increase in debt).
This chart might answer some of those questions as it shows the average maturity of the bond portfolios of these companies.
What this chart tells me is that for the next 10 years on average, these particular insurance companies (and most others that invest accordingly) will be struggling to find investment yield whether interest rates stay the same or move higher. If they stay the same, the higher guarantees they promised of 3% or more will eat away at their bottom line. If they move higher, then 60% of their portfolio or more will be affected negatively (interest rates move up, bond values move down).
Where is your insurance company invested? Chances are, you don't know. You just trust the insurance agent or broker who tells you the magic buzz words of "guaranteed" and "lifetime income."
In fact, your annuity or life insurance cash value are guaranteed only to a certain maximum through a state insurance guarantee fund. This amount will vary from $100,000 to $500,000 depending on your state.
Insurance Companies Pushing Immediate Annuities
Insurance companies are doing all they can now in getting people with money to lock in a Guaranteed Immediate Annuity with the promise of a lifetime income. Guaranteed immediate annuities are an investment vehicle that will guarantee a lifetime income for you or you and your spouse, paying you a small bit of interest and a return of your principal, making it look like you are getting a good return on your contribution. They tell you that you'll never run out of money as long as you live. Well, that is true, as long as the insurance company you get the immediate annuity from is still in business.
But these products will turn out to be the worst investment a person can make once we see interest rates move higher. A money market will give you a better return than these products will once interest rates turn higher, AND you get to keep your principal and leave it to your loved ones.
The Bottom Line
When interest rates do finally rise, banks will find it more difficult to loan and insurance company portfolios will be negatively effected.
Whether you are a bank owner or run an insurance company (or manage the investments for one), the future as well as the present is troublesome.
It's not just the Fed and the U.S. Treasury who are worried about a bubble bursting with the rise in interest rates. Banks and Insurance Companies are facing the same type of problems. This presents an even stronger case in pointing out that most every investor in the U.S. has good reason to buy the only "real" safe haven that will be left standing; gold and silver. What percentage of your portfolio is invested in gold and silver bullion? Doesn't it make sense for you to diversify?
You buy insurance for your home, auto, life, and health, but of these four things, how many do you actually collect on? Your portfolio, especially at this point in our nations history where the entire globe is financially interconnected by the Central Banking System, needs the insurance that physical gold and silver provide. All Central Banks own gold as insurance against their own currency problems. They always have. It's about time you do to.