Negative Interest Rates: A Storm Is Brewing
Issue: April 2015 L/H General Industry, P/C General Industry Download PDF English By Tad Montross
The phenomenon of negative interest rates potentially poses a perfect storm for insurers as it simultaneously pulls at both levers affecting returns: investment results and underwriting results. It also adds volatility to currency markets, compounding the risks to multinational insurers.
Economic Environment
Since the financial crisis in 2009, central bankers have been reducing interest rates to decrease borrowing costs and jump-start growth in their economies. They have also been purchasing bonds to increase the money supply and spur inflation. The result has been an increase in bond prices and a decrease in yields, in effect benefiting debt holders at the expense of savers. The negative interest rates that prevail in many European countries today reflect this phenomenon.
A study in the United Kingdom estimates that over the period of 2007 to 2014 savers have lost over £1.3 trillion due to foregone interest, which has directly benefited debtors and, to a lesser extent, the banking industry.1
Savers Bailing out Debtors
While we have not seen a study like this on a global basis, the magnitude is likely to be in the tens of trillions of dollars.
The impact of monetary policy on debtors and savers can be approximated using the Taylor Rule, a tool used by central bankers when expected inflation rates and employment rates differ from targets. It suggests that central bankers should increase interest rates at times of high inflation or when employment is above full employment levels, and that they should decrease rates when inflation or employment is low. Had the U.S. Federal Reserve followed a policy based on the Taylor Rule, the interest rate target would have been approximately 1.7% higher on average over the period 2008 to 2013.2
The longer-term impact of the trillions that have been added to sovereign balance sheets is not known, but in the short run these monetary policies have created significant foreign exchange volatility.
Implications for Insurers
Today's negative interest rates complicate not only the industry's asset management strategies, but also the pricing, loss reserving and capital management strategies for Property/Casualty and Life/Health insurers around the world.
Insurers have historically been significant fixed-income investors. In a world of suppressed and historically low interest rates, there are temptations to reach for yield by reducing credit quality and/or increasing duration. Both strategies increase risk. Increased foreign exchange volatility further increases risk for fixed-income portfolios and the potential mismatch of assets and liabilities.
The negative rates we see across much of Europe are reminiscent of Japan during the past 20 years and introduce the possibility of negative nominal returns with positive real returns depending on inflation/deflation. Some may assume that negative interest rates translate into deflation. While there may be economic deflation, there may very well be insurance inflation at the same time.
Insurance pricing either implicitly or explicitly considers the time value of money on float, particularly for long-tail lines of business. As interest rates have come down, the underwriting profit component of the total return has had to increase 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.3 In the United States with the 10-year Treasury yielding 2%, the combined ratio needs to be in the mid to low 90s to generate an adequate ROE. In Europe where the five- and seven-year bonds are now negative, the combined ratio needs to be even lower. Negative interest rates are a fundamental challenge for Property/Casualty insurers and more so for the Life business where calculations of the net present value of the future cash flows (premiums and losses) can go out 15 years or more.
With respect to reserving, active Life reserves are discounted today for U.S. GAAP, and the movements in interest rates around the world have created reporting volatility on a quarterly basis in recent years. Property/Casualty reserves are discounted under IFRS accounting and for Solvency II regulations. I think it is fair to say that no one had contemplated discounting loss reserves using negative interest rates until just recently.
The negative asset returns and negative discount rates for reserving will produce some interesting capital model results, making for more challenging capital management decisions.
Today we are in uncharted waters. We are likely to face choppy waters as this huge experiment of easy monetary policy plays out.
Some have called this market the “new normal” but it is anything but normal.
Endnotes
- Bank of England, ukhousebubble.blogspot.com.
- Swiss Re, Financial repression: The unintended consequences.
- Insurance Information Institute.
