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Feds Move to Keep Short-Term Interest Rates Low through 2014 Pressures US Life IndustryThe Federal Reserve's Jan. 25 announcement it plans to keep short-term interest rates near zero at least through late 2014 continues the financial and profit pressures plaguing the U.S. life insurance industry. The Fed announced that economic conditions are "likely to warrant exceptionally low levels for the federal funds rate at least through late 2014," changing its previous statement in August that the federal funds rate would remain low "at least through mid-2013," said James Gillard, senior managing economist at A.M. Best Co. The central bank is also now releasing participants' projections of the appropriate timing for raising the federal funds rate, Gillard said. "We expect the Federal Reserve to follow through on its intention to keep interest rates near zero until at least late 2014." Finally, the Fed announced its continuing "Operation Twist," which is serving to bring down long-term interest rates, Gillard said, referring to the central bank's "Maturity Extension Program and Reinvestment Policy," instituted last September. These actions are creating "an unprecedented period of low interest rates," Gillard said, noting short-term rates will have been near zero for six years if rates remain at these levels through late 2014, which will continue to put pressure on investment income and reinvestment return. The Federal Reserve's announcement means reduced reinvestment rates, less competitive spread-based products and compressed interest rate margins for life insurers, wrote Jay Gelb, an equity analyst with Barclays Capital, in a research note. However, Gillard said insurers "should have a better ability to plan and make appropriate adjustments given the Federal Reserve's new transparency in its expected time horizons for interest rate movements." Information received since the Federal Open Market Committee met in December suggests the economy has been expanding moderately, notwithstanding some slowing in global growth, according to a statement from the Federal Reserve's board of governors. While indicators point to some further improvement in overall labor market conditions, the unemployment rate remains high. The Fed has the dual mandate of controlling inflation while maximizing employment but "these can conflict," said Steven Schwartz, an equity analyst with Raymond James, in an email. The Fed is focused on fixing the housing market with Operation Twist, according to Quincy Krosby, chief market strategist for Prudential Annuities. The question is whether the central bank does another round of quantitative easing, which she dubbed as another way of saying "the printing of money." "Quantitative easing" is a monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a predetermined quantity of money into the economy. If the Fed does a quantitative easing later this year, "they'll likely be buying mortgage assets in an attempt to bring down mortgage rates even further," Schwartz said. According to the American Council of Life insurers, life insurers held $5.3 trillion in assets in 2010. At year-end 2010, 52% of their assets were held in bonds. Long-term U.S. Treasury securities in their general accounts totaled $120 billion, and the largest portion of long-term bonds were in both U.S. and foreign investments, totaling $1.6 trillion, or nearly two-thirds of all long-term general account bonds, according to the ACLI. In this environment, the life industry is mostly buying investment-grade corporate bonds with high credit quality that provide good spreads, and isn't making big buys into Treasuries, according to Mike Lillard, managing director and chief investment officer for fixed-income management at Prudential Financial. Stock life insurers tend to focus more on "spread-based" products, taking on more investment risk than underwriting risk, Schwartz said. Spread-based products, such as fixed and indexed annuities, and universal life, are those in which most of the earnings are due to the difference between the income from investments and crediting rates to policyholders, Schwartz said. Mutual life insurers tend to hold more Treasury and agency debt. Speaking during an A.M. Best Co. webinar last year, Ken Frino, group vice president of A.M. Best's life/health rating division, said variable annuities with guarantees and traditional fixed annuities are the annuities that could be most impacted by low interest rates. Other products that could be impacted most are universal life insurance with secondary guarantees; long-term care and long-term disability, Frino said.
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