Central banks in developed economies have driven interest rates down to record lows, causing investment income to fall sharply, and putting pressure on earnings. The primary challenges for property/casualty insurers are exposure to real interest rates and inflation, as well as long-run threats to capital from future rate increases. This asset-based problem requires insurers to consider enterprise-wide strategies.
Although the pace of the decline in interest rates has accelerated over the past few years, interest rates started a downward path even prior to the 2007-2008 financial crisis. As governments in Europe and the United States have attempted to contain the costs of borrowing, investors’ ability to generate investment income has eroded. Compounding this effect are the multiple policy responses to the global “Great Recession,” which have pushed interest rates to levels below where they would normally be at this point in the business cycle.
Executive SummaryConning’s chief investment officer evaluates risk/reward consequences of different duration strategies for a typical workers’ compensation insurer, concluding that while none is optimal in both stable and rising rate environments, extending is unattractive. Also discussed are asset mix considerations and the need for investment managers to coordinate with operations managers.
Insurance companies find they must plan for a potential continued decline in investment yield and income, while also considering the eventual reversion to more normal interest rates as well as the continued uncertainty in the performance of insurance products and markets. These challenges are especially complex to consider due to dynamic balance sheet interactions between assets and liabilities.
The Problem: Insurance Companies Are Being Stressed By Continuing Low Interest Rates
Property/casualty insurers have been faced with declining investment income, steady loss-cost inflation and increasing accident-year loss ratios over the past several years. For the industry overall, Conning is forecasting a combined ratio in the 103-104 range for 2012-2014. The industry’s underwriting loss, coupled with weak investment income and a historically strong capital position, means that industry-wide returns on equity (ROEs) are projected to be in the range of 4-5 percent, well below historical averages. These low ROEs weigh heavily on public company valuations, as publicly-traded property/casualty companies trade at a substantial discount to book value on average.
Assuming no major change in strategy, asset maturities and the roll-over of reinvestments into lower yielding securities will likely cause book yields to fall further. Interest rates are unlikely to recover soon, given the Federal Reserve’s stated objective to maintain interest rates at current levels for the near term and given the global demand for U.S. securities. But even if this were not the case and rates started to climb tomorrow, it will take several years to begin to bend the portfolio book yield curve upward as “old money” invested at past years’ higher rates gradually rolls off.
Insurers can expect to operate in a challenging economic environment for the foreseeable future. Sluggish global economic conditions may prolong the low-rate environment indefinitely; Japan’s low interest rates have been in place since the early 1990s. The possibility also exists for an earlier or sharp return to “normal” conditions or even a spike in inflation.
In the low interest rate environment, loss costs have continued to grow in the low-to-mid-single digit range across most lines. Loss-cost inflation is particularly pronounced for those insurers whose losses are heavily influenced by medical cost inflation. Medical cost inflation has stayed in the 5-6 percent range even as interest rates and general inflation have subsided.
For property/casualty companies that discount loss reserves, low interest rates present a unique challenge. Not only is investment income depressed, but reserve adequacy can become compromised as previously assumed discount rates could prove to be overly aggressive in the current interest rate environment. An interest rate rebound could be accompanied by a further increase in inflation, adversely impacting the asset-liability mismatch for many property/casualty companies.
What Can Companies Do?
There are a number of discrete, tactical business or investment responses that companies can take to position themselves against the uncertainty in investment performance and a deteriorating outlook for profitability. Such responses can take several forms, including changes in operations, and changes in investment strategies.
• Companies can raise prices selectively, but that is not a cure-all. Although companies are increasingly using predictive analytics and refined market segmentation to target pricing strategies and better measure profitability and persistency characteristics, competitive pressures will make it difficult for rate increases to overcome the effects of low rates without an impact on market share.
• Companies also can adjust their product mix. Property/casualty insurers can increase their proportion of shorter-tailed business, thereby reducing the impact of low interest rates on investments that support longer-tailed liabilities. However, shorter-tail business may be more volatile with catastrophe exposure and sudden liquidity demands.
• Companies can strive to control expenses in light of lower revenues. However, cutbacks can have a long-lasting negative impact on human capital and systems.
• Companies can change investment strategies. The most recent data for 2011 indicate that book yields did not fall as much as core interest rates would suggest. Some investment executives apparently have begun to respond to the loss in yield by extending duration, reducing quality or broadening into additional asset classes, resulting in modest shifts in allocations for the industry when viewed in the aggregate.
The Optimal Solution Is a Holistic Approach
The key for insurance companies is to understand their risk and return characteristics within a full range of scenarios, reflecting both asset and liability dynamics, and their balance sheet and income implications. This strategy results in optimized outcomes.
What companies should not do is adjust longstanding and carefully considered risk control parameters to react to the yield-starved markets. For any given scenario—an extended period of low rates, a further drop in rates, a return to a normal level of interest rates, or even a spike in inflation and interest rates—an effective investment approach can be designed. The challenge is selecting the correct scenario, which means predicting the direction, magnitude, and timing of future rates moves.
Duration is a key investment decision for property/casualty insurers, and particularly important when considering interest rates. Faced with low rates, many have considered two investment options: either shorten duration in expectation of an eventual increase in rates, or extend duration in expectation that rates will remain low or even decline further.
To illustrate the risks of a material change in duration strategy, we modeled a generic workers’ compensation company. Workers’ compensation insurers, like insurers of other long tailed lines, are particularly sensitive to changes in interest rates. On average, they have longer duration portfolios, are more dependent on investment income to support profitability, and have significant inflation exposures. However, the dynamics we have modeled are similar for all property/casualty insurers.
The graph below shows the change in economic value of our insurer under two scenarios—one where interest rates on average remain at current levels (“low rate,” shown in blue), and one where interest rates start at current levels but on average increase (“rising rate,” shown in green).
(Economic Value is the sum of all assets at market value, less the present value of all liabilities, plus the discounted value of future insurance operations. In terms of a formula)
The low rate efficient frontier has a typical shape, with a cash portfolio (point A) at the low risk/low reward end, and with durations extending as one moves to higher risk/higher reward portfolios. Once the portfolio duration approaches 8 years (point I), there is little to be gained from further extension.
Not surprisingly, the rising rate efficient frontier has a very different shape. In a rising rate environment, short duration portfolios do well, suffering less market value depreciation and benefiting from faster reinvestment. The optimal portfolios, represented by the tightly clustered points 1 to 11, all have similar expected risks and rewards. Interestingly, the duration of the low risk/low reward portfolio is actually slightly longer than the duration of the higher risk portfolios. The higher risk strategy is going to cash; the maximum benefit is gained if rates increase, but this strategy results in a large asset-liability mismatch.
If our insurer believes rates will stay low, the insurer should maintain, or even extend, its portfolio duration. Longer durations offer more reward at the cost of increased risk. Assuming the insurer is comfortable with his current risk profile, there is no reason to shorten duration.
On the other hand, if our insurer is confident rates are going to rise significantly, then it should shorten duration. This increases reward and decreases risk—a clear win. An ultra-short duration portfolio provides the best outcome, but moving to cash is generally impractical as:
- Book yield and investment income will plunge; short term interest rates are extremely low. With combined ratios above 100 in many lines, operating losses are likely unless the expected rate increase comes quickly.
- Since most bonds are still held at unrealized gains, the company may incur significant tax expenses.
- Regulators, rating agencies and other stakeholders may question management’s ability to time interest rates.
However, even if cash is ruled out, there is still room to shorten the portfolio. We modeled outcomes in the rising rate environment for portfolios with durations of 3, 5 and 7 (portfolios spanning the range B through H in the current low interest rate environment). None of these portfolios is optimal (i.e., is located on the efficient frontier) in the rising rate scenario, but the shorter the duration the better the outcome.
It is clear there is no portfolio that is optimal for both a stable and a rising rate environment. Our analysis shows that the best decision for the workers’ compensation insurer comes down to either remaining at its target duration (a duration of 5 is a reasonable proxy for the typical workers’ compensation portfolio), or tactically shortening the portfolio. Extending is clearly unattractive. The best choice depends on the relative likelihood of the different economic scenarios, and on portfolio specifics, such as the effect on investment income.
The Impact Of Expanded Asset Strategies
Alternative mixes of investments can prove to be more efficient in risk and return than a simple duration decision. Returns can be improved with less risk by adjusting the mix of specific classes of investments, again within the context of an integrated risk/ return optimization framework.
- Allocating to asset classes that deliver a greater portion of their return as income when compared to alternatives with similar risk characteristics. Examples are high dividend-paying equities and convertible bonds versus the broad stock market.
- “Barbelling” in credit by allocating a portion to high-yield bonds while keeping the same overall portfolio quality.
- Considering lower-liquidity instruments, such as commercial mortgage loans, private placement bonds, and Working Capital Finance Investments, which offer that offer incremental returns in exchange for a reduction in liquidity versus investments of comparable credit quality.
(See related article, “Investment Strategies: Consider Asset Mix Considerations,” for more strategies.)
The Need for Enterprise-Wide Strategies
There is no simple solution to the complex challenges that insurers face. Investment management and operating management need to coordinate their tactical solutions with a clear understanding of risk and return. Not doing so could result in changes on one side of the balance sheet making matters worse on the other side of the balance sheet, and for the company as a whole.
The complicated interaction of assets and liabilities and their differing sensitivities to interest rate changes require insurers to re-evaluate their investment and business approaches. Although interest rates may remain low for the near term, insurers nonetheless must be prepared to deal with the current situation as well as the unforeseeable future and the paths that take them there.
The markets have witnessed many shocks over the past few years, and none has been widely anticipated in timing or magnitude. They can happen again. A strategic approach that considers both investment and operating solutions will likely produce the highest probability of success navigating the uncertainty that lies ahead.