The Economy

Can the Fed Stop Interest Rates from Spiking?

The CFO of New York Life says U.S. companies should be prepared for a dramatic jump stemming from the Federal Reserve’s loose monetary policies.
Vincent RyanFebruary 15, 2013

As CFO of a financial-services company, Michael Sproule is hoping for the Goldilocks scenario for interest rates: a slow and steady rise that warms up the economy and boosts margins. Not too hot, not too cold, but just right.

Indeed, the finance chief of the huge life and health insurer New York Life has particular numbers in mind for his ideal: a 25 to 35 basis-point increase a year for a decade.

But Sproule, an executive with 40-plus years of experience, says that when it comes to New York Life running its business, hope is not a strategy. With central banks worldwide printing money at record paces, a scenario à la 1979 to 1982, when U.S. interest rates spiked 700 basis points over a three-year period, is possible. Further, many CFOs in financial services don’t think it’s a question of whether a dramatic rise in interest rates will happen, but more a question of when, he told CFO editors during a recent visit to the media company’s New York office.

The 7 Habits of Highly Effective CFOs

The 7 Habits of Highly Effective CFOs

Download our whitepaper to discover the technical and behavioral skills needed to lead your business forward.

Neither Sproule nor his number crunchers is smart enough to predict where interest rates are going, he says, and therefore they don’t “bet” one way or the other.

A spike in rates might sound mildly surprising, especially when the Federal Reserve Bank has pledged to continue monetary easing until the unemployment rate is driven down to 6.5%. That process, Federal Reserve board members admit, could take years. Fed chairman Ben Bernanke “has done everything he can to ensure that through 2016 interest rates are going to stay at these artificially low levels,” says Sproule. But with central banks in the euro zone, Japan, and England also in the process of amassing enormous balance sheets, the Fed will be hard-pressed to “manage interest rates indefinitely,” the finance chief says. 

“The issue is whether all this excess liquidity can be managed out of the system at the right moment in time,” says Sproule. While Bernanke has said he will be able to put the genie back in the bottle, Sproule says no one has actually had to do it in a situation comparable to today.

To be sure, life insurers in general can take a big hit if interest rates spike. One effect, however, would be that fixed-income investments on the balance sheet would go from substantial unrealized capital gains to substantial unrealized losses. Insurers “have to manage their companies so that they don’t create a perception problem in terms of the size of those unrealized losses relative to surplus capital,” Sproule points out. (In insurance terms, “surplus capital” refers to that part of the available capital held by the company in excess of solvency capital requirements.)

But a “Japan-like” scenario, persistent deflation, and very slow economic growth, in which the 10-year interest rate stays at 2% indefinitely, would be just as bad for life insurers — maybe worse for some — and a scenario some experts view as being just as likely.

Yet while long-term near-zero interest rates would not be “fun” for New York Life, they might be quite threatening to many of its competitors, Sproule contends. “Over time, clearly it would have a meaningful effect because margins would be squeezed.” While New York Life would have to develop “an array of new products” to meet these circumstances, Sproule says, the 168-year-old mutual company would come through nicely because of its capital strength and because so much of its business is made up of participating whole-life policies, through which the effects of interest-rate movements are passed along to policyholders.

The portfolio crediting rate in this scenario (the crediting rate is the portion of the portfolio’s yield that is credited to the policyholder) would remain far above the current low interest-rate levels for a long time, says Sproule.

In contrast, many other insurance companies have sold products that guarantee a certain level of return to the customer, and a Japanese scenario of sustained low interest rates could clobber them because they would stand to absorb the full brunt of poor investment results, he says, noting that such companies wouldn’t be able to “get these mistakes off [their] books. No one is going to relieve you of those,” Sproule says.

Life-insurance companies manage the duration of their assets relative to the duration of their liabilities. Significant interest-rate moves up or down present “convexity risk” for an insurer: a risk based on the theory that as interest-rate levels change, the behavior of policyholders changes, and the behavior of the company’s assets changes accordingly, says Sproule.

If interest rates rise, for example, policyholders may let their policies lapse because the rate is no longer competitive with the new money rates. In that event, the liability durations assumed by insurers would shorten. At the same time, if the insurer holds, for example, some residential mortgage-backed securities on the asset side, it would find prepayment rates declining and the duration of these assets lengthening as homeowners stop refinancing their loans.

Extremes of interest-rate behavior are something insurers must be prepared for. In the current U.S. economic climate, they look a lot more probable than the Goldilocks scenario.

4 Powerful Communication Strategies for Your Next Board Meeting