Interest in Insolvency

Underwriting-related risks are the main cause of insolvency in the property and casualty insurance industry. However, financial market risk is also a significant contributor. Insurance companies hold large financial portfolios, exposing them to a wide range of financial market risks. Canadian p&c insurers are conservative investors with many firms further reducing investments in equities and increasing their share of government bonds in recent years. This reduces exposure to equity market volatility and risk, but it also increases exposure to interest rate risk. In recent years, with declining or stable rates, interest rate risk has had a low profile. In 2005, interest rate risk increased, and with it the potentially adverse effect of a shift in market interest rates on insurer balance sheets.

INTEREST RATE RISK

Generally, interest rate changes are gradual. Bond portfolios turn over steadily and increase in market interest rates is usually accompanied by increases in book valuation rate for assets, which lowers interest rate risk. Interest rate risk will be significant if there is increased volatility in interest rates; historically, insurer insolvency rate is at least partially correlated with interest rates, particularly volatility in interest rates. Higher interest rate volatility increases insolvency risk, particularly for insurers operating at the margin.

A.M. Best’s 2004 study on insolvency analyzed the impact of interest rate levels on financial impairment. The study noted the industry’s combined ratio closely tracked the movement in interest rates, concluding that higher interest rates and inflation indirectly affected underwriting.

A.M. Best’s study indicated very little correlation between interest rate levels and financial impairments. Nonetheless, 44 examined failures were associated with an overstatement of assets. For another 309 insurers, A.M. Best did not identify a particular cause of insolvency. PACICC’s research shows a high correlation coefficient (74.3%) between volatile interest rates and these otherwise unexplained failures in the U.S. insurance market.

RATE VOLATILITY

Although it’s unlikely interest rate volatility is the only or primary cause of failure, the high correlation coefficient does suggest that greater rate volatility increases the probability of insolvency for vulnerable companies. Generally underrated, interest rate risk seems to be a contributing factor in approximately 41% of insurer failures in the United States and many in Canada.

The correlation of interest rate risk with financial impairments caused by overstated assets highlights the risk volatile interest rates can pose to an insurer’s assets. Changes in interest rates affect the market value of fixed income securities, the largest component of Canadian insurer portfolios.

Public information about the minimum capital/branch adequacy of assets tests (MCT/BAAT) has only been available since 2003, but the data indicate the tests are sensitive to interest rate volatility. PACICC has identified a strong negative correlation between the MCT/BAAT score and the Bank of Canada overnight rate lagged over four quarters. In fact, the correlation coefficient is -92%. This suggests that with increased upward volatility in interest rates, available regulatory capital falls. The magnitude of the change in the MCT/BAAT ultimately depends upon the structure of each insurer’s portfolio.

Interest rates can also adversely affect the present value of insurer liabilities. Ultimately, the impact depends on the discount rate applied to the liabilities and the amount of inflation experienced. Experience says insurance loss reserves are at least partially inflation-sensitive. Payments in tort liability products, for example, depend partly on awards at the date of settlement, and reflect price and inflation expectations. For personal automobile lines, accident benefits are subject to inflation as health care costs increase.

Historically, interest rate changes and general inflation are highly correlated to claims costs and liabilities. Problems can arise when there is a divergence between inflation experienced by an insurer, and the discount rate on loss reserves (based on the expected return on bonds held in the insurer’s portfolio). In such cases, insurer asset values and liabilities may go in different directions. This is an additional interest rate-related factor placing pressure on insurer solvency. Ultimately, the risk of changing interest rates is the potential reduction of equity as the gap between assets and liabilities narrows.

The key component of interest rate risk is not the level of interest rates, but their volatility. Research found little correlation between interest rate levels and financial impairment. However, a volatile interest rate environment, even when rates are low, increases the risk of insolvency. At the extremes, two rules generally hold: interest rate volatility increases the risk of financial impairment; while a stable interest rate environment reduces risk. Overall, solvency risk is heightened when elevated interest rate volatility coincides with a softening in the cycle. This occurred in the early ’90s, when insolvency was high.

Canada’s interest rate volatility was low by historical standards until it increased last year. In 2005, interest rate volatility was 40% higher than the previous four years, as interest rates began rising in late 2005. The relatively rapid rise in market interest rates has increased interest rate risk for insurers. Between 2003 and early 2005, interest rates were generally stable or declining, with positive implications on the market value of insurer portfolios. In 2005, and the first quarter of 2006, interest rates rose by 125 basis points. At an industry aggregate level, rising interest rates generated downward pressure on the MCT/BAAT of about nine percentage points for PACICC member companies.

The Bank of Canada and the five big banks suggest the Canadian economy is operating at full capacity in early 2006 so interest rate volatility is very possible.

SUMMARY

Underwriting is the main cause of insurer insolvency but external factors can adversely affect vulnerable insurers. PACICC’s research confirms volatile interest rates contriubute to many insurance failures.

However, Canadian insurers have improved their capitalization and are well-positioned to manage this increase in risk. The situation is improved as volatility remains below that of the early and mid -’90s. .