Negative Interest Rates - The Perfect Financial Storm
Negative interest rates could create a perfect financial storm for the insurance industry, simultaneously putting investment returns and underwriting adequacy under unsustainable pressure. Compounding the risks for multinational insurers, a persistently low interest rate environment will fuel volatility in the currency markets.
Why is this happening? Since the financial crisis, central banks have reduced interest rates to jump-start economic growth. They have purchased bonds to grow the money supply and spur inflation, resulting in an increase in bond prices and a decrease in yields.
But insurers are significant fixed-income investors, and in a world of suppressed and historically low interest rates it’s tempting to reach for yield by reducing credit quality and/or by increasing duration. Both strategies magnify risk. Foreign exchange volatility further heightens risk for fixed income portfolios and it widens the potential for a mismatch between assets and liabilities.
On the liability side, insurance pricing either implicitly or explicitly considers the time value of money on float, particularly for long-tail lines of business. The problem is that as interest rates have fallen, the underwriting profit component of the total return has to rise in order for insurers to generate similar ROEs.
A 100% combined ratio in 2010 for the U.S. Property/Casualty industry produced a 7.9% ROE versus the same 100% combined ratio in 1979 producing a 16% ROE. With 10-year Treasury yielding 2%, the combined ratio now needs to be in the mid- to low 90s to generate an adequate ROE.
In Europe where five- and seven-year bonds are now negative, the combined ratio has to be even lower to produce an acceptable ROE.
Negative interest rates are a fundamental challenge for Property/Casualty insurers and even more so for the Life business, where calculations of the net present value of the future cash flows (premiums and losses) have a horizon of 15 years or more.
Solvency II will be implemented in less than a year’s time: I think it’s fair to say that no one contemplated discounting loss reserves using negative interest rates until just recently.
Negative asset returns and negative discount rates for reserving are sure to produce some interesting capital model results, adding complexity to crucially important capital management decisions.
Some call this market environment the “new normal” - but it’s anything but normal. We are navigating through uncharted waters and, as this huge experiment in easy monetary policy plays out, the storm warnings will likely grow in intensity.