The Interest Rate Spike of the Early 1980s: An Epic Dislocation in the Life Insurance Business
From Mike Cohen
Perspective: The life insurance business was a relatively straightforward business from its inception and early growth years in the nineteenth century up until the late 1970’s. Whole life insurance, with a fixed rate of return on its savings component in the 4% range, was sold by career agents who were ‘captive’ to (sold exclusively for) their companies. The business model clearly appeared to be sound. An inside joke at life insurance companies (insurance humor being what it is) was that “All you had to do was turn the lights on” and the business worked.
An unprecedented economic event occurred over a span of 4 1/2 years, from late 1976 until the third quarter of 1981, that changed all that. Interest rates spiked to levels never before seen in the United States. The prime rate rose from a cyclical trough of 6.25% in December, 1976 to unheard of levels of 20% or higher in April, 1980, crossed the 20% threshold again for a two month stretch in December, 1980 through February, 2001, and yet again from May through September, 2001. This shock challenged literally everything about the life insurance business:
1) Guaranteed interest rates offered by whole life products were not (at all) competitive with other investment options consumers could get. Policyholders were borrowing heavily from their policies, as the loan interest rates were well below rates they could earn on their investments. This dynamic spawned the financial strategy known as “buy term and invest the difference”, and drove insurers to develop products that paid competitive (relative to the market) rates, such as Universal Life
2) Bonds values were far ‘under water’ (below cost), as the rates of interest they paid were substantially below what investors could earn on other instruments. Without wanting to realize capital losses on their sale, insurers generally had little choice but to hope for a lower interest rate environment.
3) Given that cash flow was leaving companies in substantial and potentially crippling amounts, many companies made one of two disastrous choices (and often both):
– They paid their producers first year (heaped) commissions to rewrite business already on the books so it wouldn’t surrender, ruining the profitability on that business
– They sold business offering current interest rates (GICs were an egregious example) to raise cash, but they weren’t able to invest the cash at comparable rates, locking in a negative spread, and losses. This dynamic spawned the creation of a critical financial/ actuarial technique, Asset Liability Management.
As companies’ profitability reeled from these and related problems, they looked much closer looks at their profit fundamentals and sought ways to improve results. One area of many came under intense scrutiny … distribution costs. In this new environment, companies across the industry learned that an entirely new distribution model was critical for survival, let alone success.
My company at the time (a life insurer) undertook a major strategic analysis in 1983 … products, markets, distribution were the key areas, but not the only ones. I was a member of the four person team heading this critical project. Overheard in one of our working sessions:
“If we could only come up with a diamond in the rough”, said one of the other members on the project team, a close friend of mine.
“We’ve already had it, and it endured for over 100 years.”, I replied. “We now need to develop significantly different solutions, and more fundamentally focus on entirely new ways to think about our business”.
The life insurance industry had reached a dislocation. All of its strategic dynamics changed, and its companies were forced to change with it in order to survive. It took many years; many industry observers would say more than a decade, but the industry was able to essentially reinvent itself and prosper.
Now, in 2009, the life insurance industry is in the throes of the current dislocation as is the entire financial services industry, and its companies are faced with the challenge of responding to a new set of dynamics.
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