Of Interest

With the post-financial crisis low interest rate environment persisting longer than most economists expected, Swiss Re’s latest Expertise Publication looks at an extended history of Canadian interest rates and how the current environment is impacting insurers. Although p&c companies are not affected to the same degree as their life industry counterparts, low rates nevertheless hurt.

LOWER FOR LONGER

Nominal interest rates in Canada have been on the decline for about three decades. Rates have remained stuck at historically low levels for about half a decade now – with the Bank of Canada pausing on any rate hikes since September 2010, and the 10-year government benchmark rate below 3.5% for more than four years.

For some time after the financial crisis, the ultra-low, long-term rates were due to low growth, limited inflation pressures and massive monetary stimulus. Today, growth is getting back towards more normal levels, or even slightly catching up with the output gap, as is inflation, but rates remain low.

Monetary policy, including policy measures outside of Canada, is still a main driver, although other factors are also at play.

For example, vast savings in emerging markets have been offered up as a weight on rates. Similarly, actions by some countries’ authorities to control their exchange rates by buying Canadian and United States government bonds are maintaining downward pressure on long-term interest rates across North America.

A few commentators even talk of a “new normal,” where the environment seen today is here to stay. At the same time, others worry about the impact of all the monetary stimulus, particularly in the U.S., on future inflation.

INVESTMENT YIELD UNDER PRESSURE

The low share of multi-year contracts coupled with an absence of product guarantees mean that property and casualty insurers are generally less sensitive to interest rate changes than life companies. Nevertheless, long-tail lines of p&c insurance – such as casualty – are dependent on investment returns earned on underwriting cash flows and, therefore, are negatively impacted by the current low rates.

Property and casualty investment yields have fallen markedly over the past few decades, from low double digits in the early 1990s, to around 6% by the early 2000s, to just 3.2% for 2013, the last full year for which data is available. In 2014, medium- and long-term government bond yields have dipped to below end-2013 values again, putting further pressure on investment yields and profitability.

In general, profitability of p&c companies is driven by both underwriting and investment performance. Additionally, pricing for p&c products takes expected future interest rates into account, as the premium charged to the buyer is arrived at by calculating today’s value of all the future expected cash flows on the particular product – the concept of time value of money.

However, p&c products are typically re-priced every year, and this can mitigate the impact of low rates and declining investment income to a great degree. Overall profitability has, thus, not declined to the same extent as investment yields.

Even so, for a given return on equity, a lower investment yield would necessitate an improvement in the combined ratio, including raising premium rates. The adjustment via higher premium rates comes with a lag and may be incomplete.

Moreover, falling yields cannot be fully compensated for by premium rate increases in times of economic weakness. That is because capital and capacity are inflated at the same time, intensifying competitive pressures while insurance buyers’ demand is low.

On the other hand, to the extent that the prolonged low interest rate environment forces companies to focus on making an underwriting profit, this may be a small positive.

HAUNTING SPECTRE OF INFLATION

There is a much bigger potential threat to p&c insurers, and that is persistent inflation, which some fear may be caused by the massive monetary stimulus still ongoing in some places, and the possibly unclear path to unwinding it.

A spike in rates caused by surging inflation would lead to a confluence of falling asset values with simultaneously rising claims costs. Higher claims costs would necessitate reserve increases and erode profitability, and again, would have the greatest effect on long-term lines such as casualty. Additionally, general expenses would also be impacted.

The costliest would be a longer period of high inflation. Even a temporary spike can be challenging, as it would likely coincide with heightened uncertainty.

Expenses and p&c claims would likely increase, and volatile markets and policy uncertainty could see economic growth stutter. This scenario is much less stable than the lower-for-longer one, compounding the risks to insurers.

A sudden switch to high interest rates would also mean a rapid decline in the value of insurers’ fixed income portfolios – p&c insurers in Canada, in particular, held nearly three-quarters of their investable assets in interest-sensitive bonds at the end of 2013. The more closely asset and liability durations are matched, the lower the vulnerability of the balance sheet and capital position to interest rate changes.

Given the relatively short-term nature of p&c liabilities, asset liability matching (ALM) is not as difficult for p&c as it is for life products. ALM risk cannot be entirely eliminated, however, as prices of assets and liabilities do not move in a linear manner. Even slowly rising rates would not be a clear boon if insurers had to pass on expected higher investment returns to policyholders as a result of competitive pressures.

A NEW NORMAL?

Gradually improving rates are the most likely path forward, as accelerating economic growth closes the output gap, and both the Canadian and U.S. monetary policy authorities start to lift policy rates. However, this still implies several years of low rates. A continued “lower-for-longer” environment is also a possible outcome, as exemplified by Japan since the mid-1990s.

Despite the projected uptick in the interest rate environment over the next few years, past averages of long-term interest rates – such as the 7.4% over the prior 40 years, or the 5.2% average since the Bank of Canada adopted inflation targeting in 1991 – are unlikely to be repeated, and the “run rate” once the economy returns to full capacity is closer to 4.5%.

Though this is not quite the pessimists’ Japan-redux scenario, such long run levels are nevertheless not expected until 2017 at the earliest, and, thus, insurers’ investment results likely remain under pressure for some years to come.

The challenging scenario of persistently high inflation and interest rates is the least likely, mainly due to the strong credibility of the Bank of Canada, and its solid inflation-targeting focus.

DARE TO BE PREPARED

History has shown that a number of different interest rate paths are possible, and that actual outcomes often deviate greatly from previous expectations. Enterprise Risk Management (ERM) is the most crucial component of insurer preparedness for all eventualities, including interest rate changes.

The insurance industry is generally more aware of ERM than other sectors, but even in 2012, a Towers Watson survey in North America found that almost a quarter of financial services companies, including insurers, did not have an ERM program. Thus, more awareness and implementation is necessary.

Canada may be somewhat ahead of the curve, as the federal regulator requires the appointed actuary to develop an understanding of the company’s financial sensitivity to several risk categories considered material to the firm through Dynamic Capital Adequacy Testing (DCAT).

But incorporation of DCAT into a firm’s risk management processes is not mandatory, and many insurers reportedly still view it as purely a compliance matter rather than as a risk management tool.

Additionally, as of January 2014, another step toward a fully functioning ERM framework for insurers has been mandatory in Canada – the Own Risk and Solvency Assessment (ORSA). The ORSA process should provide a company’s management with an assessment of the current adequacy of risk management, as well as the likelihood of future adequacy, and adds an Office of the Superintendent of Financial Institution (OSFI) draft guideline from January 2013, “serve as a tool to enhance an insurer’s understanding of the interrelationships between its risk profile and capital needs.”

Life insurers’ most effective means to manage interest rate sensitivity going forward is new product design. Most p&c products are underwritten on an annual basis, so no significant product re-design is necessary to deal with the persistently low interest rates. The duration of long-tail liabilities is inherent in the underlying risks insured and usually not a function of product design.

However, given the limited pricing power in today’s environment, an increased focus on operational efficiency is likely. Underwriting know-how and discipline remain key success drivers.

At the same time, as is done in some markets, inflation sensitivity can be reduced by contract design, for example through introducing “claims made” policies or adding sunset clauses – approaches that shorten the tail and, hence, the development risk.

Similarly, contract clauses indexing premiums, limits and deductibles to inflation can also help. While such designs are not the market practice in Canada, it is something to keep in mind for the future. Additionally, reinsurance can partially protect primary p&c companies from inflation surprises.

Many insurers already have solid risk management processes in place and have also taken a number of the other aforementioned steps to minimize their interest rate sensitivity, both to a lower-for-longer scenario and to an unexpected spike.

However, risk management is a continuous process and, therefore, it is important to periodically re-evaluate the approach, to update scenario testing and to make sure that the company is well-positioned to deal with the various scenarios the future may hold.