September 27th, 2012

Growing Interest Rate Sensitivity

Posted at 1:00 AM ET

David Flandro, Global Head of Business Intelligence, Julian Alovisi, Assistant Vice President and Lucy Dalimonte, Senior Vice President

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Although (re)insurers’ investments in higher-grade fixed income securities have calmed nerves for now, it is only logical to expect an increase in interest rate sensitivity for portfolios with lower yields to maturity. This creates the potential for negative balance sheet impacts should interest rates rise suddenly.

Figure 1 demonstrates a hypothetical scenario in which a rapid, unexpected and sustained 1.5 percentage point (pp) increase in inflation expectations is accompanied by a 1.7 pp rise in yields on a five-year duration, average AA-rated bond portfolio. Although it is assumed that insurance pricing would increase in this environment, it is a virtual certainty that claims costs would also rise. In the example shown in Figure 5, the increase in inflation expectations coincides with a USD1.6 billion increase in reserves as claims costs escalate. At the same time, the increase in prevailing market interest rates leads to a USD1.5 billion decline in the value of the bond portfolio. The total combined effect is a USD3.1 billion shortfall.

Figure 1overcoming-figure-5

¬†Whether this risk will come to pass and whether today’s quantitative easing will lead to unexpected inflation remains less than certain. It is nevertheless noteworthy that carriers with conservative investment allocations and low equity gearing are relatively unhedged against inflation and interest rate risk.

Overall, insurers are faced with a number of economic challenges as concerns over the future of the Eurozone, the U.S. “fiscal cliff” and slowing emerging market growth continue. Eurozone fears are now focused on Spain and Italy since they are structurally important to the stability of the single currency. Carriers have reacted to this threat with a flight to safety in investment portfolios and a movement into high-grade government and corporate bonds. Although this has reduced exposure to sovereign default in the short term, it has made balance sheets more susceptible to interest and inflation rate risk in the medium term. Lower yielding securities have also reduced investment returns, placing additional pressure on underwriting results.

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