Low Interest Rates
While a concentration of assets in short-duration, high quality bonds has protected many (re)insurers from volatile asset markets, it has also lowered yields on investment portfolios. Due to concerns around slow growth and a double-dip recession, interest rates remain low. Indeed, interest rates in the United States, United Kingdom and the Eurozone are at or near post-war lows (see Figure 1). US policymakers announced in August that they will hold interest rates near zero through at least mid-2013 as long as the unemployment rate stays high and the outlook for inflation is “subdued.” With declining returns on fixed income portfolios, the (re)insurance industry can no longer rely on investment income to offset underwriting losses.
With yields on five-year Italian sovereign debt hitting an EU-era high of 7.7 percent in November, the European debt crisis continues to rage, slowing growth in the region and keeping investors on edge across the globe. The market’s view of the likelihood of default is illustrated by widening spreads on credit default swaps (CDS) as shown in Figure 2. Italy, unlike Greece, may be too large to be bailed out, with debt exceeding USD2.6 trillion. Austerity measures may yet succeed in reducing debt levels and stabilizing markets, but they are politically unpalatable and will take time once fully implemented. In the meantime, contagion is slowing growth and impacting markets.
The sovereign debt crisis has been contributing to equity market volatility over the past year. The MSCI World Index began 2011 in positive territory but dropped 17 percent in the third quarter due in part to concerns about the US debt ceiling before recovering through the middle of the fourth quarter. The Chicago Board Options Exchange Volatility Index (VIX) reached its highest point since the financial crisis in the third quarter of 2011 and remains high (see Figure 3). Most major stock indices have shown a similar pattern, with sharp drops over the first nine or 10 months of the year, followed by a volatile partial recovery in the fourth quarter.
Credit markets were also volatile in 2011, but yields of higher grade issues have fallen. The US sovereign debt rating was downgraded by S&P to AA+ from AAA in August on fears of political deadlock and rising debt levels. Concern around negative implications of the downgrade quickly subsided, however, and the market for US Treasuries has remained strong (yields on 10-year Treasuries are down from 3.3 percent at the beginning of the year to below 2 percent at year-end).
Yields on peripheral Eurozone debt in particular, and lower grade issues in general, have been volatile and are up dramatically in some cases, including Italian sovereign debt as noted above. Many (re)insurers saw the market value of their existing bond portfolios fluctuate widely during the year, and some portfolios are currently showing steep losses.