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Home / Insurance / Triple-I Blog | The Fed's Rate Move poses long – term challenges for P / C insurance companies

Triple-I Blog | The Fed's Rate Move poses long – term challenges for P / C insurance companies



Dr. Steven N. Weisbart, CLU, Triple-I Senior Vice President and Chief Economist

"FOMC's actions are likely to keep long-term interest rates exceptionally low for several years."

The Federal Open Market Committee (FOMC) of the Federal Reserve Board recently set out its goals and strategies for at least the next few years – a description of an economic framework that they will maintain beyond the time frame they usually describe. The length and parameters of this framework will have a significant impact on the property / accident industry y .

FOMC says it will keep short-term interest rates close to zero, probably for several years – perhaps until 2023, possibly longer. Insurers do not invest much in short-term instruments – to the extent that they do, it is to have cash available to pay receivables. They mainly invest in medium- and long-term bonds and similar interest-paying instruments with a fixed interest rate that provide stable income that, together with premiums, covers claims and operating expenses. Insurers raise and lower premiums – partly in response to changes in investment income – to maintain profitable operations.

As the return on these investments generally tracks short-term interest rates, FOMC measures are likely to keep longer-term interest rates exceptionally low for several more years.

A sign the Fed will use to determine when interest rates should be raised is when inflation, measured by the PCE (Personal Consumption Expenditure) deflator, is maintained at over 2 percent so that average inflation including the most recent the years corresponds to 2 percent. To estimate what this means, consider Figure 1 . It shows that the PCE deflator since 2012 has been below 2% (compared to the same month, last year) for the most part. The average over this range was 1.40%. But the Fed may not go that far back to calculate its long-term average. For example, since 2017, the PCE deflator averaged 1.69%. If the deflator averages 2.4% until 2023, the average from 2017 to 2023 will be 2.01%.

Chart 1

Prices f alling since the 1980s

Based on the FOMC's new framework, medium and long-term interest rates will at best remain at their current historically depressed levels in years. One consequence of this is that bond insurers are maturing and will be reinvested at lower interest rates than they currently offer.

Current interest rates have generally fallen since the early 1980s. Chart 2 shows this decline since 2002, due to the yield on ten-year US government bonds (the blue line) with a constant maturity, and its effect on the portfolio return for the P / C insurance industry over the last two decades (the gold bars) .

Figure 2

P / C insurance companies invest primarily in bonds, but not just US government securities. They also invest in corporate and municipal bonds, both of which generally yield higher interest rates than US government bonds because they are more risky. The return on corporate and municipal bonds will probably loosely track government interest rates.

P / C insurers also receive investment income from dividends on ordinary shares that they hold. These dividends are likely to be affected by corporate profits, which may be depressed at least for the duration of the current recession.

A transition to shorter maturities?

How will insurers react to these persistent conditions? If the recent behavior is any guidance, they are likely to move to shorter maturity bonds to maintain the flexibility to switch back to long-term, higher-return investments when interest rates eventually rise again. Figure 3 shows this pattern for shortening the term during the years since 2009 when prevailing prices fell. From 2009 to 2019, the proportion of bonds with a maturity of one to five years rose from 36% to 41%, but those with 10 or more maturities fell from 19% to 11%.

Figure 3

What is remarkable about this strategy is that – since short-term bonds yield less than long-term bonds – the shift results in an even lower portfolio return than the industry would have achieved if maturities were unchanged during this time period . It sacrifices short-term opportunities for the flexibility to eventually absorb longer-term gains.

If insurers continue this strategy, the transition to short-term bonds, combined with continued low interest rates, could lead to a scenario over the next five years that looks like Chart 4 which includes the return 2015-2019 for historical context .

Figure 4

Of course, future portfolio rates may differ from this scenario. For example, insurers can realize significant capital gains or losses. For example, the portfolio return in 2012 was almost two percentage points above the US Treasury Department's 10-year return that year due to realized capital gains.

On the other hand, if interest rates rise, low-yield bonds available for sale would suffer unrealized capital losses, which would be a direct reduction in the policyholder's surplus.

In a typical year, the industry shows capital gains of $ 5 to 10 billion, but any number outside this range would affect the portfolio return for that year. Capital losses can also be due to investments affected by bankruptcies or other business setbacks caused by the recession. Doubtful bonds must be reported in the balance sheet.


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