Why insurers don’t want a sudden hike in interest rates

Insurers might be happy if lending rates rise by a few percentage points, but a financial executive with one mutual warns a sudden rise in interest rates carries a noticeable risk.

The Bank of Canada announced in December it is keeping the overnight rate at 1%. That’s a quarter of a point higher than this past July but a far cry from 1981, when the overnight rate crested at 21%.

The overnight rate 10 years ago was 4.5%, shortly before the subprime mortgage market collapsed south of the border. The ensuing financial crisis led to the failure of some investment banks and the temporary federal takeover of American International Group Inc.

“For the first time in many years, interest rates are beginning to rise,” Andy Taylor, chief financial officer at Gore Mutual, wrote in a statement to Canadian Underwriter Thursday. “Although at the surface this is positive for the long-term investment returns of P&C insurance companies, it also poses significant risk if not managed prudently.”

For example, the market value of bonds tends to drop as interest rates rise, Taylor added.

Bonds that were issued before the interest rates rose tend to be less popular among investors than new bonds issued at higher interest rates. This means that an insurance company holding bonds that were issued before interest rates rose is at risk of getting a lower price when they sell those bonds than they otherwise would have.

“A gradual rise in interest rates is the best scenario for insurance companies,” Taylor told Canadian Underwriter Jan. 5. A two- to three-percentage point increase in interest rates would return the industry to pre-financial crisis levels and overall returns on equity “could potentially be higher than before the global financial crisis,” he said.

This could be achieved using “financial models to run thousands of potential asset-mix scenarios to optimize for certain variables such as volatility, income or capital efficiency,” Taylor added. “You use these models to select your asset-mix strategy which typically is more complex than just stock and bonds and also includes other investments such as mortgages, infrastructure real estate or other alternate investment classes.”

A low interest rate environment has suppressed the industry’s investment income for some time. Industry-wide investment income for Canadian property & casualty insurers dropped from $2.27 billion in the first nine months of 2016 to $2.23 billion during the first nine months of 2017, MSA Research reported in a paper released last week.

Worldwide, reinsurers could have “more pricing flexibility” and “earn back losses more quickly following significant loss events” if interest rates rise, A.M. Best said in a report released in December.

The U.S. Federal Reserve System announced in December that it raised its key interest rate —the third time it has done so in 2017. The Associated Press reported that the Fed foresees three additional hikes in 2018. In the United States, the short-term rate is now in range of 1.25% to 1.5%.

Full year, the Canadian insurance industry had net investment income of $2.5 billion in 2016, up from $2.2 billion in 2015, but down from $3 billion in 2014, A.M. Best reported this past August.

Bank of Canada Governor Stephen Poloz said during a speech at the Canadian Club in December that the overnight rate is staying at 1%, The Canadian Press reported earlier. The decision not to raise rates was based in part to uncertainty over trade and a greater-than-expected weakness in exports.

At the time, Poloz warned that higher interest rates will likely be required over time, even though the bank will proceed with caution by carefully assessing the incoming data, CP reported.