In difficult times, consumers reduce or eliminate expenses that are considered non-essential. Streaming subscriptions in the UK, for example, saw 1.66 million Subscription Video on Demand (SVoD) services cancelled in the second quarter of 2022, according to market research firm Kantar, as the effects of higher inflation began to be felt in the country as households reallocated wages to fund ever higher utility bills and food costs.
Unlike parts of its property and casualty insurance cousin, and like SVoD services, life insurance is not always a need to have. And the current cost of living crisis could see a rise in lapse rates as those with life and health cover decide that they can’t justify the premiums in the current economic environment.
On the surface, an increase in lapse rates spells challenges for the life ILS sector. Portfolios in this space are heavily built on value-in-force (VIF) transactions, where the life ILS manager lends to an insurance company or agent based on the value of a block of existing life-related insurance policies and receives payments in return from the profit stream of those policies; rising lapse rates means that there are less policies in the portfolio to return capital, leading to write-downs.
The first line of defence against this potential risk is an obvious one.
“Obviously we bake in some wiggle room for potential risks, like lapse rate risk. Making transactions at less than a 100% loan to value ratio is clearly the first step. Essentially, this buffer should absorb that first deviation of risk in a life ILS portfolio,” said Adam Robinson, Head of Life at investment manager Securis in London.
The current macroeconomic challenge is pronounced in the United Kingdom. The country’s inflation rate is over 10%, and industrial action is taking place on an almost unprecedented scale as workers in industries ranging from healthcare to railways demand pay increases to cope with the additional costs.
It’s not quite as pronounced in North America, however. The inflation rate in the U.S. was 7.1% as at the end of November 2022 and 6.8% in Canada for the same period, and, whilst that’s higher than in recent years, it’s also better than in the U.K. This dispersion – at least, in developed economies, where life ILS managers do almost all their deals – provides diversification of risk in the space.
“It can be tempting for investors to look at situations like what’s happening in the U.K. and think that’s the case for other markets,” said Robinson. “But a good asset manager will be diversified by geography as well as product type. Whilst the U.K. market is arguably at higher risk of rising lapse rates right now, it’s not necessarily the same case in North America.”
Geographical diversification isn’t the only free lunch in the life ILS space. Product diversification becomes more of a consideration for portfolio construction in times of heightened risk; some life-related products are more resistant to lapse rate risk than others, and the nuances of these products come to the fore. Additionally, life ILS managers can further diversify portfolios by investing in a mix of lapse and non-lapse risk products.
“If you look at funeral plans, these tend to be purchased by lower income groups because it’s a comparatively high cost. At first glance, one might think that these are at higher risk, but they have historically had stable lapse rates,” said Robinson. “And in other products, policies sometimes offer premium holidays and/or a reduction in benefits, which again means lapse rates, insofar as full termination of the product, don’t increase to the extent and offers some level of portfolio protection.”
There’s a flip side to portfolio exposure lapse rate risk. Whilst existing deals might be at higher risk of rising lapse rates, pricing for new deals adjusts to compensate; consequently, those added to a life ILS portfolio in 2023 improve the overall portfolio’s risk/return profile.
“If we think that a particular country, like the U.K., is at higher risk of rising lapse rates, we’ll price that in through higher interest rates or lower LTVs [loan to value] – i.e., effectively a higher price for the insurance company. And we are seeing higher pricing right now, across the board. But it comes down to risk and return, and demand from insurance companies for capital. Sometimes, seemingly unattractive markets can become attractive,” said Robinson.
Lapse rate data is usually published with a lag. Premiums can be yearly or quarterly, as opposed to monthly, which means that an insurance company, let alone a life ILS manager, has a more limited view into whether that policy will lapse or not. Also, grace periods mean that a policy that lapses in December, for example, might not be recorded as a lapse until March.
It’s the same with aggregated data, which life ILS managers use to take the temperature of their market. The American Council of Life Insurers, for example, publishes an annual fact book, which contains life insurance lapse rate data, but the most recent version of the report, published in November last year, contains data through the end of 2021, when macroeconomic volatility was more benign (the Association of British Insurers didn’t respond to a request from Life Risk News asking if it maintained this data for U.K. insurance companies in time for publication).
All this means that its currently unclear what the exact lapse rates were for full year 2022. But for Robinson, regardless of what they were, he’s confident that life ILS best practice should insulate the industry to a high degree.
“We take a similar approach to constructing our portfolios as a diversified public equity manager might,” he said. “There’s a significant amount of actuarial modelling and analysis in our space to ensure that we’re mitigating risk, whether that’s lapse rates or something else. So yes, the cost-of-living crisis in the U.K. might seem to represent a headline risk for the life ILS space, but prudent risk management techniques, like geographical and product diversification, means that investors should feel better about the industry than it seems.”
