Key Points

  • Life insurance companies collect premiums up front and invest that money until claims are made.

  • Life insurance companies try to align their obligations with their investment decisions, so the bonds they hold are often held to maturity.

  • Rising yields are generally positive for life insurance companies, but not entirely.

  • 10 stocks we like better than Prudential Financial ›

Life insurance companies like Prudential (NYSE: PRU) and MetLife (NYSE: MET) are generally very conservatively managed. That makes sense, since they take on financial obligations that can extend for decades, and they need to ensure they have the capital to meet them. This dynamic is an important part of why rising yields on 30-year Treasury bonds are largely a positive for insurance companies. Here's what you need to know.

What does a life insurance company do?

Life insurance companies sell insurance that you don't actually want to use. In fact, you won't use it; your heirs, or whoever you designated as the beneficiary, will. That's a bit of an overstatement, since life insurance companies also sell retirement-oriented products like annuities. But the real point is the time frame that's involved. You generally buy life insurance or a variable annuity a long time before it will be needed.

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The life insurance company's job is to ensure it has the financial capacity to meet the obligations it has assumed. Those obligations can be decades away, so the premiums collected are generally invested conservatively. Usually, life insurance companies try to align their investments with the timing of their obligations. Often called matching liabilities, this generally means that bonds are bought and held to maturity.

If a bond is held to maturity, changes in price and yield between purchase and maturity aren't particularly important to a company's long-term outcomes. So rising rates just mean that a life insurance company can reinvest maturing bonds into higher-yielding ones, generating more interest income. From a big-picture view, rising yields are a win for life insurance companies like MetLife and Prudential.

Notably, nearly 73% of Prudential's investment portfolio is held in bonds. For reference, equities account for only about 1% of its portfolio, with the other assets focused on mortgage securities. MetLife's portfolio is a bit more aggressive, with bonds making up roughly 67% of the portfolio, stocks 0.02%, and mortgages and other institution-level assets (real estate and partnerships, for example) accounting for much of the rest. Still, the big story is the large bond exposure, which means that rising rates will boost the income these large life insurance companies produce.

There are other benefits, as well, since yields are used to calculate long-term liabilities. The math is complex, but higher rates reduce liabilities, freeing up capital for other purposes, such as selling more policies. And higher rates reduce the burden of guarantees on previously sold products. All in, rising yields are net positive for life insurance companies.

There are still some negatives to consider

That said, rising rates are not just positive. There are some notable negatives to think about, too, even though the positives outweigh them.

For example, bond prices and bond yields move in opposite directions. Essentially, existing bond prices fall so the yields the bonds offer match the current market yield. If such bonds are held to maturity, this dynamic isn't that important, as noted above. However, it still reduces the value of a life insurer's portfolio over the short term until existing bonds mature and can be rolled over to new, higher-yielding bonds. An insurance company's book value can be pressured as yields rise.

Also, life insurance products sold when yields were lower may no longer be competitive with those currently available. That can lead some customers to ditch their old products and buy new ones. That churn can reduce the benefit that higher yields offer life insurance companies. The caveat here is that financial products tend to be fairly sticky, so this is likely to be an issue for a relatively small number of policies.

All in, higher yields are a win

Life insurance is a complex industry where companies must align their investments with their financial obligations. That materially changes the story for the bonds companies like MetLife and Prudential own, as they are often held to maturity. This specific dynamic makes rising yields a win for life insurance companies, but there are other dynamics to consider, both positive and negative. All in, however, higher yields are likely to be a net positive, potentially for decades to come.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.