How insurers can respond to higher interest rates
We live in uncertain times and face many profound societal and economic challenges. These now include inflation, which has become a major concern for the first time in decades. Supply chain and labor market disruptions have contributed to rising prices and higher worker salaries. Economic growth coming out of the pandemic and, more recently, conflict in Eastern Europe have resulted in much higher energy and materials costs, as well as increased volatility in the capital markets.
Because of these developments, inflation seems likely to persist for the foreseeable future and is raising concerns among insurers. For property and casualty (P&C) carriers, the challenge has been more acute, with premiums lagging behind the rate of inflation, while claims costs have increased month by month. There’s also increasing awareness in all industry sectors of the potential for asset-liability mismatches and resulting implications for surpluses.
As global workforce numbers begin to approach pre-pandemic levels, some supply chain pressures are likely to ease over the course of the year. However, the political situation in Eastern Europe almost certainly will result in sustained high prices for oil and gas, many basic foodstuffs, and some vital metals and minerals. Even though they’ll reduce disposable income, these developments mean inflation is likely to remain a global concern for some time.
Against this backdrop, the US Federal Reserve (the Fed) has mulled over its response to inflationary pressures. Historically, rising inflation led to correspondingly higher interest rates, but a seemingly fragile economic recovery and initial assumptions that inflation would be short-lived led the Fed to leave near-zero interest rates in place through winter of this year. However, in line with the outcome of the January Federal Open Market Committee meeting and Chairman Powell’s comments to Congress on March 2, the Fed announced a quarterly rate hike of 25 basis points at its March 15-16 meeting. It also said it could potentially raise rates again later in the year depending on economic conditions.
Possible impacts
Although rates remain low by historical standards, any increase has potentially significant impacts on insurers. Carriers should be aware of and plan accordingly for the ways higher treasury rates could affect:
- Product structure and features
- Product pricing
- Reinsurance and deals
- Asset adequacy and capital requirements
- Investment management
- Financial reporting and taxation
Product structure and features
For life and retirement providers, higher interest rates will broadly reduce reinvestment risk and make rate guarantees less expensive from an economic standpoint. However, too sharp a rise will introduce disintermediation risk, which will negatively impact balance sheets. (Carriers should keep in mind the mass lapse scenarios of the early 1980s). In contrast, a gradual change in rates will mitigate these risks, but carriers would need to reset rate guarantees and pricing more frequently than they have recently in order to respond to market pressure on book value guarantees.
In addition, higher interest rates, coupled with fluctuating equity markets punctuated by periodic crashes, are likely to make equity-indexed life insurance and annuities less attractive to policyholders. As rates rise, insurers will be in a better position to offer insured products with more substantive interest rate guarantees.
Moreover, life and annuity providers will face less pressure on the margins they earn from legacy blocks of annuity and insurance premiums with high minimum rate guarantees. With rising rates, they may offer fewer buyouts on products like fixed annuities. Conversely, we may see increased activity in blocks that were too expensive to sell under a low-interest-rate environment, given the bid-ask gap between buyers and sellers.
In contrast, P&C carriers could face difficulties with coinsurance terms. In an inflationary/higher-rate environment, coverage may not be adequate to make policyholders whole after a loss, especially a catastrophic one. Although minimum coverage is legally mandated in many cases for individuals and businesses, restitution shortfalls and correspondingly aggrieved policyholders can become problematic for carriers. In such an environment, prescient insurers will review product structure and features with underwriting and brokers to ensure coverages are adequate and go beyond legally required minimums.
Consequences
Rising US treasury rates could significantly change how insurers operate. In particular:
- The search for yield will be less challenging than it was when rates were near zero. Carriers will be able to consider rebalancing portfolios, perhaps moving back to more traditional investments and relying less on alternative asset classes. This will require a review of financial reporting processes.
- Rising interest rates effectively increase capitalization ratios for insurers that offer long-dated interest-rate guarantees. This will relieve some of the pressure on performance that has led many carriers to divest interest-rate-sensitive books of business.
- The deals environment appears likely to remain hot despite the rate increase. However, any subsequent increases could cause distressed credit scenarios as highly leveraged deals come under pressure. Moreover, reinsurance transactions could decline because insurers will have less need to reinsure or transfer interest rate risks to other parties.
- In the previous period of high inflation and rising interest rates, P&C carriers saw fixed-income asset value deterioration, unpredictable claims trends and poor underwriting performance. The sector now seems better prepared to adequately manage these risks, but companies that maintain longer-tail casualty reserves will be more likely to experience reserve volatility in a high-inflation environment because of rising medical costs and social inflation.
Additional contributors to this article include, deals partner John Marra, tax managing directors Mark Smith and Rob Finnegan, and actuarial partners Alexandre Lemieux and Marc Oberholtzer.
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