Question

Life insurance companies are exposed to interest rate risk because they tend to maintain large, long term bond portfolios whose values decline when interest rates rise.

What is the reason that all U.S. states have insurance commissions? What do such commissions do?

Answer 1

Interest rate risk for insurance companies is a significant factor in determining profitability. Although rate changes in either direction may affect its operations, an insurer's profitability typically rises and falls in concert with interest rate increases or decreases.

Changes in interest rates can affect the assets and the liabilities of an insurance company. Insurance companies have substantial investments in interest-sensitive assets, such as bonds, as well as market interest rate-sensitive products for their customers.

Drops in interest rates can decrease an insurance company's liabilities by decreasing its future obligations to policyholders. However, lower interest rates can also make the insurance company's products less attractive, resulting in lower sales and, thus, lower income in the form of premiums that the insurance company has available to invest. The net impact on the company's profitability is determined by whether the decrease in liabilities is greater or less than any reduction in assets that is experienced.

Lower interest rates can also negatively impact an insurance company's risk profile as an equity investment if analysts believe the company may have difficulty meeting future financial obligations. Lower levels of equity investment mean lower levels of assets for insurers.

While the precise effect of interest rate changes on a specific insurance company may be uncertain, historical analysis shows that the overall trend is for the profitability of the insurance sector to increase in an environment of rising interest rates. Overall price-to-earnings (P/E) ratios for insurance company stocks usually increase in fairly direct proportion to increases in interest rates.

The conceptual framework introduced above suggests that, to understand a company's exposure to interest rate risk (i.e., how changes in interest rates affect its equity value), it is important to appreciate the impact of interest rates on both the value of the firm's assets as well as its liabilities. In the case of life insurers, the sensitivity to interest rate changes of both investment assets as well as policyholders' claims (i.e., liabilities) could have a significant impact on equity value. In addition to influencing growth, interest rates clearly have an impact on an insurer's risk profile, notably via exposure to interest rate risk. For example, with respect to the asset side of the balance sheet, managers in the life insurance industry face the challenge of structuring their investment portfolio so that the firm can meet its future obligations on policies written.

By influencing a company's perceived growth prospects, risk, and profitability, interest rates have the potential to influence equity valuations. However, life insurers can employ a "variety of hedging techniques, such as matching asset and liability durations," to help insulate firm value from changes in interest rates. Duration for a bond investment is defined as "the number of years until the investor receives the present value of all income from a bond (including interest and principal) and is used to gauge a bond's sensitivity to interest rate changes." That is, the higher the duration, the greater the sensitivity to interest rate changes. Similarly, the duration of a liability would measure the liability's sensitivity to changes in interest rates. Accordingly, if the durations of both assets and liabilities are equal, changes in the interest rate environment should impact both the assets and liabilities equally (on a percentage basis), thus limiting the impact on the value of equity.

With this in mind, many insurers employ an "immunization" strategy in order to reduce the risk of loss in a changing interest rate environment. While the concept of duration matching seems simple enough, in practice, a perfect hedge against interest rates is difficult to attain for life insurers. As a result, equity values for life insurers tend to be subject to at least some level of interest rate risk.

A state-level position within the state’s finance department, an insurance commissioner is either elected or appointed, depending on the state. Insurance commissioners act as advocates for consumer protection, regulators of insurance, and educators who are able to provide consumers with information that pertains to the insurance system within a particular state. While insurance commissioners’ duties may vary across states, their roles are generally the same: act as intermediary figures between individual consumers and insurance companies within the state.

Insurance is regulated at the state level in the US. Each department is tasked with one overarching duty: regulating insurance for the protection of consumers. To that end, they serve several roles: licensing insurance companies and agents, regulating insurance policies and rates, reviewing insurance company practices, and serving consumers through education and complaint resolution.

As a resident of your state, you are entitled to the below services from the office of your state’s insurance commissioner:

• Handles complaints filed with state insurance agencies
• Enforces the insurance laws of their particular state
• Responds to consumer inquiries
• Provides educational and informational resources to their constituents
• Answers more specific questions about consumers’ health coverage plans and policies as well as their rights and protections as individual consumers
• Regulates and licenses health insurance companies
• Ensures that insurance rules and laws are executed

The office of the insurance commissioner needs to be aware of any problems that you have with your insurance company. The best way to ensure this is to file a formal complaint with your state’s insurance commissioner. To do this, click on your state above and go to your state’s insurance commissioner’s website.