On Ultra Low Interest Rates

Fed Chairman Ben Bernanke keeping rates ultra-low well after the US economy strengthens

As the US teeters towards the edge of its fiscal cliff, the two presidential candidates may have squabbled this week in the first television debate about their methods  but both agreed that growing the weak American economy is the only way to reduce the massive budget deficit. Earlier Ben Bernanke, chairman of the Federal Reserve, defended his aggressive policies to stimulate demand surprising many in the financial markets by his plan to keep interest rates ultra-low well after the economy strengthens; in other words to at least 2015 and beyond. Of course interest rates have been trending downwards for a few decades but rather than simply wait for a rebound, this prolonged period of near-zero levels now requires insurers to re-examine both their underwriting and investment strategies.

For non-life insurers, it is long-tail casualty business, where claims payments are spread out over many years that the impact of lower investment returns on assets backing claims reserves will have the most profound impact on profitability. In their excellent Sigma study “Facing the Interest Rate Challenge” published last month, Swiss Re suggest that the industry’s pricing adjustment to lower yields tends to be gradual and effected with a time lag. Certainly on the back of a long run of good results generally in the casualty sector, claims reserve releases from older years have been masking the creeping inadequacy of pricing levels in companys’ published statements. Despite this, as the market prepares for the year-end treaty renewal season, the signs are that casualty reinsurers will be increasing premiums to reflect not only their weak investment earnings but also the expectation that inflation will escalate future claims costs.

Whilst the poor return in financial markets might impact on underwriting at least in longer tail classes, the extent to which a new world of ultra-low interest rates will change investment strategies is perhaps less clear. Insurers sit on a mountain of cash and each day need to put it to use. Typically the emphasis for companies is on preserving capital rather than solely maximising total return. In particular the key priority of most firms is to match assets to their insurance liabilities in duration. However an insufficient volume of bonds with distant maturity dates often prevents this in practice and using derivatives instead introduces an unwelcome counterparty risk.

Whilst it might prove more expensive under Solvency II, this lack of long term investment opportunities and the painfully low returns being generated in the current environment might persuade insurers to search for higher yields by adopting a more open approach to the asset classes they support. Indeed in a recent survey conducted by Towers Watson, over thirty percent of industry Chief Financial Officers expected their company’s investment strategy to become more aggressive. Sixty percent indicated an increase in their allocation to credit risk assets such as high-yield bonds, bank loans and emerging market debt.

Currently the publically-quoted London Market insurers are all clustered around a miserly 1% investment contribution to their combined ratios suggesting that at least for the time being they remain universally positioned in lower yield investments. Yet risk tolerances are bound to be tested tempting some companies away from traditional safe fixed income portfolios. However a too high concentration in alternatives might lead to unpleasant surprises as Chaucer discovered in 2008 when sizeable hedge fund losses largely prompted its sale two years later to the Hanover Group. Whilst a degree of diversification to bump up returns might work in the short term, if history is not to repeat itself, in the ultra-low world, insurers would do well to remember that it is the liability not the asset side of the balance sheet where its risks should truly sit.

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