Low Interest, High Uncertainty

In its release of mid-year 2012 financial results, Munich Re noted that one of its main challenges was neither natural disasters nor was it the economic malaise in Europe, but something else — low interest rates. Specifically, the company said it “deems the challenge of the still very low interest rate levels to be far greater than that of the volatility of the financial markets or the worsened global economy.”

Similarly, in its application for an 11.2% rate hike for compulsory auto insurance, the Insurance Corporation of British Columbia (ICBC) pointed out a primary reason behind the increase is that “declining interest rates in a period of global economic uncertainty has significantly reduced the yield that ICBC is obtaining on invested premiums collected and basic equity.”

These are just two examples of how an aberrantly long period of meager interest rates is coming home to roost for insurers and reinsurers, which cannot rely on fat investment yields to bolster underwriting losses.

It has been that way for some time, reports Graham Seeger of MSA Research. “The entire industry has seen industry-wide (investment) yields (excluding capital gains, capital losses and expenses) drop from 3.76% to 2.52% over the last five years,” Seeger noted in the most recent issue of MSA Quarterly Outlook Report, released in April.

Seeger explained the significance of loss of yield to the property and casualty insurance industry because of low interest rates and paltry bond returns. “Based on 2011 year-end invested assets of $109 billion, a 1% increase or decrease in the effective yield of a portfolio could theoretically produce an over $1.1 billion change in before-tax investment income,” he observed. “To offset each 1% change in yield would therefore require a 2.4% change to the approximately 100% combined ratio of the last two years (2011 and 2010).”

Ernst & Young made a similar observation in its report on the Canadian property and casualty industry in January.

Book yields take hit

“The consequences of a sustained low-interest rate environment are of great concern to p&c insurers,” the consulting firm noted. “If current conditions prevail through the next three years, companies’ book yields may decline by approximately 30 basis points, putting pressure on their earnings and premium rates.”

Canadian property and casualty insurers place about 80 to 85% of their assets in fixed income investments such as bonds, most of which are government and investment-grade corporate bonds. The returns of these investment vehicles have been in a “downward spiral” with “no short-term likelihood of reversing as bonds roll over into lower yielding instruments,” Seeger noted in the MSA quarterly outlook.

Other industry observers have pointed to similar trends in investments. Moreover, low interest rates have tied insurers’ hands even tighter as companies are supposed to set loss reserves based on investment yields.

“(Historic low interest rates) have hurt profitability for Canadian p&c insurers through lower investment earnings and lower reinvestment rates, but also through negative impact on underwriting results as the Canadian insurers are required to set loss reserve discount rates based on the investment market yields,” Standard & Poor’s observed in its overview of the industry last December.

In early September, Bank of Canada Governor Mark Carney announced he would hold off on any increase in interest rates to head off a burst of consumer price inflation and to counter a “slowing of activity across advanced and emerging economies.” There are no plans in the near future for a change in the benchmark rate.

Risky investments

So, what are the insurer strategies for coping with chronically low interest rates? One tactic for companies is to look at boosting returns through potentially riskier investment vehicles.

According to a recent survey of chief investment officers (CIOs) by Goldman Sachs Asset Management (GSAM), some are doing just that.

The poll of CIOs of 152 global insurers representing $3.8 trillion in assets found that the current environment is “challenging,” with yields resulting in lower investment returns. GSAM calls the near-term outlook “bleak” as insurers expect investment opportunities to deteriorate or hold steady.

“The results of our survey suggest that while insurers are concerned about the environment, they are seeking to enhance returns,” GSAM noted in the report, Seeking Return in an Adverse Environment. “Insurers are migrating down the corporate credit quality spectrum via increasing allocations to high yield, bank loans and mezzanine debt. In addition, insurers intend to increase their allocations to such asset classes as real estate, emerging market debt and private equity.”

In the survey, 26% of insurers expect to increase overall investment risk, while 14% expect to decrease risk.

Respondents cited the sovereign debt crisis in Europe as the main macroeconomic risk, while the prolonged low-yield environment posed the greatest investment risk to their portfolios.

Standard & Poor’s also observed a willingness among insurers for greater investment risk. “The relative appetite for investment risk returned and insurers are considering strategies to boost their investment income,” the rating company reported. “As a result, we observe some increase in relative allocation to preferred shares, common equities, and other alternate investments. Also, within the bond portfolio, we notice a marginal shift toward lower-rated bonds. Standard & Poor’s believes a further shift toward higher-risk assets will continue as insurers seek to improve yields.”

Another tactic for insurance companies involves stricter asset-liability matching processes. “Asset liability management (ALM) — managing the matching of assets and liabilities — is more challenging in a declining yield environment,” stated Ernst & Young. “P&C insurers thus need to develop more sophisticated ALM approaches, which can reduce variability in their surplus positions — for example, increasing the asset duration by investing in longer-term assets offers the potential for additional yield, as well as more proper asset/liability matching as the liability durations extend.” 

Assets as back-up

A recent survey of 16 equity analysts by Towers Watson also discovered that the property and casualty insurance industry should take a careful review of asset-liability matching. In its report, Investment Unwrapped for the P&C Insurer, “the nature of the liabilities and the solvency position are the two main factors that should influence the level of investment risk,” Towers Watson noted.

“The nature of the liabilities was the most popular response (from analysts), backing up the overarching view that the assets should be there to back the liabilities and underwriting activities, and not act as the primary driver of return,” the report stated. “The greater the uncertainty in the liabilities, then the lower the level of investment risk.”

In terms of asset allocation, Towers Watson added that “there is strong support for making the assets match the liabilities as far as possible, and for diversifying the investments across asset classes and geographically.”

Interestingly, Seeger of MSA Research observed that “relatively few CFOs we have spoken to claim to be closely matching asset durations to those of their liabilities.”

Solid preparation

The goal for insurance companies in asset-liability matching and investment asset selection should be a strong risk management and capita l program, Ernst & Young recommends.

“The magnitude and implications of low interest rates highlight the need to improve risk management and capital programs, and better prepare for the impact of extreme events,” the organization noted. “A sound risk management program is one in which the risk appetite is defined, the appropriate risk tolerances are established and relevant stress tests are identified to measure financial exposures.”

Of course, declining investment returns from low interest rates and bond yields may portend a more disciplined approach to underwriting and pricing on the business side for property and casualty insurers. How this plays out in the next year or two should be of interest to buyers and sellers of insurance alike.

“We believe investment earnings will remain under pressure because low interest rates could persist,” Standard & Poor’s stated. “We also believe that insurers face reinvestment risk as maturing assets get reinvested at lower interest rates. Therefore, in our view, the insurers should renew their focus on underwriting with a more disciplined approach to pricing,” S&P added.

“The trade-offs between maximizing yield and preserving capital, while at the same time juggling capital rules and tax efficiency, are difficult, particularly when several key determinants, such as equity portfolio capital weightings and actuarial accounting rules are in flux,” Seeger concluded.

“And all that is before insurers take a position on market and rate direction. We are not naïve enough to assume that this stark information will cause changes in underwriting discipline, but the reality is that, without such discipline, insurers will not justify their cost of capital and, indeed, put their capital at risk. A situation that is not good for insurers, their brokers or the policyholder they serve.”