Bridgeway Analytics - Mon, 08/28/2023 - 13:47

Changes to negative Interest Maintenance Reserve and implications

Statutory Accounting Principles are designed to provide transparency over solvency by separately reporting the value of reserves and surplus that are part of admitted assets. Reserves represent the value of assets required to support financial risks, benefits, and guarantees associated with the policies, with the remaining value of admitted assets reported as surplus, sometimes referred to as 'Capital and Surplus,' and used in to provide an adequate margin of safety. Life insurance policies and fixed-income assets are largely accounted for symmetrically at cost and insulated from interest rate fluctuations. Interest Maintenance Reserve (IMR) is an accounting construct designed to safeguard against the potential misrepresentation of surplus due to asset sales and keep the anticipated investment yield consistent with that needed to support the policies.

In a declining interest rate environment, an insurer could sell fixed-income assets, recognize gains, and increase surplus. In reality, the sale and reinvestment would be in lower-yield assets with insufficient interest payments to support policies. This shortfall highlights the ongoing need for the gains to support the policy block rather than, say, be paid off as a dividend. To align the balance sheet with the economic reality, IMR defers interest rate-related gains from fixed-income asset sales and requires them to be amortized through income over their remaining life. Without the IMR offset (i.e., through the deferral of the gains), the surplus would inappropriately portray a false representation of financial strength.

Similarly, fixed-income portfolio sales in rising interest rate environments could result in a misleading reduction of surplus. The economics mirror those above, with the company reinvesting in higher-yielding assets with interest payments that exceed those needed to support policiesthat directionally offset the realized loss. The NAIC only recently adopted admittance of negative IMR as an asset in surplus and capital, with qualifications on an interim basis; amortized negative IMR had already been incorporated into earnings. Prior to allowing for admittance of IMR offset (i.e., through the deferral of the losses), the surplus was inappropriately showing decreased financial strength, which was increasingly constrained in the context of the recent dramatic rise in interest rates. The perverse incentives had insurers focus on managing statutory financial outcomes, limiting fixed-income transactions, and deviating from long-standing investment practices, including prudent asset-liability management (ALM) and risk management behaviors related to portfolio rebalancing. This seemingly obscure piece of accounting is impacting a broad set of investment strategies and business models, including the likes of pension risk transfer (PRT).

Life insurers' balance sheets in the United States are robust, and solvency is not under question, with insurance policies experiencing directionally equivalent movements in valuation as fixed-income assets. Nevertheless, the stakes are high, with life insurers facing close to an estimated $700 billion of unrealized losses on fixed-income investments reported on Schedule D alone, coupled with our empirical analysis of insurers’ fixed-income trading activity that suggests qualifications for admittance possibility resulting in life insurers facing continued constraints with managing their fixed income portfolios prudently. Acknowledging the need for a more thoughtful long-term solution, an ad hoc group is likely to be formed to explore long-term solutions reflecting the 2025 sunset of the temporary guidelines.

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