Swiss Re’s sigma report analyzing the effect on the insurance industry of the continuing low interest rates doesn’t paint a pretty picture. They have been at historic lows for several years. For instance the nominal yield on a 10-year U.S. treasury bond is around 2 percent, but Swiss Re points out that the real yield is effectively zero.
Kurt Karl, Swiss Re’s chief economist, presented the report at the Reinsurance Rendezvous in Monte Carlo earlier this week. He pointed out that there is “no benefit for insurers” from the expansionary monetary policy the U.S. the UK and other countries have embraced, as they finance their activities from premium payments.
The downward trend, which began after interest rates peaked in the early 1980’s, shows no signs of reversing in the near future. The general consensus, gleaned from a highly unscientific survey of insurance executives at the conference, indicates that the condition will last for at least three more years, and probably longer. 5 to 7 years was the most common response.
The sigma report notes that “while the current low interest rates help over-indebted borrowers deleverage their balance sheets, not everyone benefits from them. Insurers, as large institutional investors managing around $25 trillion or 12 percent of global financial assets, suffer greatly from low investment yields. The impact of low interest rates on insurers also affects policyholders because the cake shrinks for all – translating to fewer benefits or to higher premiums for equal protection.”
However, the low rates haven’t been a particular concern until recently “because only current premium income − a fraction of total investments − is invested at [low] market yields.” It’s becoming a problem because the debt instruments with higher yields are maturing, and can’t be replaced at the same level.
Astrid Frey, co-author of the study, explained: “Interest rates have a delayed impact on insurance investment portfolios, allowing insurers time to react but also tempting them to postpone necessary remedial action in hopes that interest rates will rebound.” As that now appears unlikely, the re/insurance industry will effectively be unable to realize a return on investments, which is greater than the currently low inflation rates.
While the study points out that the situation poses greater problems for life insurers, P&C re/insurers will also be affected. As they have no control over either interest rates or inflation, about the only things the P&C industry can do is tighten up underwriting standards, a worthy goal in itself, which could see combined ratios improve, and/or raise premiums.
That may be a solution, but given current economic conditions and low growth in most developed countries it’s hard to see across the board increases in premiums. It’s possible in some lines, such as professional liability, which have been affected by increases in claims, but as a general proposition it doesn’t look likely.
Swiss Re’s study posits three possible future scenarios. The most widely accepted foresees: “1) Global economy recovers; 2) Central banks normalize policy rates; 3) Inflation increases only moderately; 4) Typical business cycle.”
This would be the perfect scenario for insurers, as “the rise in interest rates would not be driven by unexpected inflation; P&C claims reserves would be adequate, and profitability wouldn’t be impacted.” This would allow re/insurers to “adjust premium rates only marginally over the business cycle.”
The two other possibilities are a “Japanese style” recession with interest rates remaining low for a long period and zero or negative growth. The third scenario posits a “surge in interest rates,” which would also cause a rise in inflation that would affect industry profitability “as claims reserves would prove insufficient” and it would be subject to “claims inflation.”
However it works out the re/insurance industry will be trying to find solutions to the fall in interest rates for some time to come.
Source: Swiss Re
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