Insurance Companies Could See Profits Drop if Mortgage Rates Rise

Insurance companies that invested heavily in some types of mortgage-backed securities could lose profits--and customers--if interest rates keep going up.

The value of the securities, created with pools of home mortgages, has declined because fewer people are taking out new mortgages or refinancing existing loans while interest rates are rising.

When income from investments shrinks, that puts pressure on an insurance firm’s ability to keep paying customers competitive rates on annuity-type products.

Insurance companies and banks are among the biggest investors in mortgage-backed securities, owning nearly half the $1.5 trillion in mortgage-related securities held by investors last year, according to industry estimates.

Although not all those securities have fallen in value, many have, and they’ll continue falling as long as interest rates stay where they are or go up.

The reason is that the income streams from the securities are based on payments from first and second mortgages, and the pace of new mortgages and refinancings has slowed considerably since the Federal Reserve Board began hiking interest rates early this year.

This could prove troublesome for insurance companies, especially life insurers, which derive a quarter of their profits from investing the premiums they earn in stocks and bonds.

The spread is the difference between the interest that life insurance companies pay to annuities customers and the interest the companies make on their investments.

When interest payments approach or exceed the level of interest income, earnings fall. How much profits will be squeezed depends on what happens to interest rates and which types of mortgage-backed securities are in insurers’ portfolios, analysts say. If interest rates continue to rise gradually, profits could be flat or fall a few percentage points.

But a spike in interest rates could help drive earnings down 10% or more this year, said Keith M. Buckley, an analyst at Duff & Phelps, a ratings company based in Chicago.

Insurance companies could also lose customers as a result of thinning spreads. If a company can’t offer competitive interest rates on annuities because it’s making less money on its investments, customers could choose to take their money elsewhere.

Some companies have more than half their bond holdings in mortgage-backed securities, analysts estimate. Insurance companies bulked up on these investments in the past few years because, while riskier than traditional fixed-maturity investments like privately placed bonds, the investments promised higher yields.

One type of mortgage-related security can be especially risky. Called collateralized mortgage obligations, or CMOs, these securities are created by taking pools of mortgages, stripping the principal and interest payments, and making a separate bond issue from the payments.

The payment flows are packaged into different classes payable after different time periods. Those with predictable life spans usually have lower yields than those with less predictable maturities. The higher-yielding classes are riskier.

Payouts from CMOs depend on the rate at which mortgage holders repay their loans. When interest rates are low, people tend to refinance mortgages and pay off the loans faster. When interest rates rise, they don’t refinance and the maturities lengthen.

Investors who bet on CMOs tied to principal-only payments do well when interest rates are low because mortgages are paid off quickly. Those that bet on interest-only CMOs fare poorly because there are no interest payments on mortgages that have been paid off.