How casualty insurers can hedge against interest rate risks

28 November 2016

Structured products or working layer excess of loss reinsurance could be the answer to growing pressures.

The soft market is clearly a major challenge for casualty underwriters. Yet there are potentially more worrying factors at play that ultimately could decide the fate of casualty lines.

The political and economic uncertainty that dominates the operating environment makes forecasting key financial and macroeconomic trends a challenge, especially for a line of business that requires pricing based on long-term assumptions.

Interest and inflation

Interest rates and inflation are key drivers for casualty lines. The direction of interest rates is key as insurers, collectively, are now the largest holders of high-grade, short and medium-duration fixed income securities.

‘Lower-for-longer’ interest rates could lead some insurers to extend the duration of investments in a low-rate environment. As existing bond investments mature, insurers will face a reinvestment risk as they are likely to invest in bonds at much lower yields. If you believe that yields will be ‘lower-for- longer’ then investment maturity will be extended at historically low rates.

Political uncertainty creates some doubt, however, on the ‘lower-for-longer’ theory. Depending on the outcome of the US presidential elections, rates could go up to more normal levels. This would create the double whammy of reducing the value of the bond portfolio and having a longer exposure to those same declining assets.

Riskier bets

The current environment may also encourage insurers to take riskier bets, on both the asset and liability side. Companies are more likely to chase yield on riskier bets on the asset side in a low-interest rate environment, causing strain on the balance sheet.

Increased volatility in realised investment losses and gains can already be seen in financial results, while a number of major US insurers have reported ‘one-off’ investment-related losses in recent quarters.

Uncertainty over reserve development is another factor that could help to push casualty and liability rates upwards. Analysis of reserving trends by JLT Re (Viewpoint Report, ‘Enough in Reserve?’) found evidence of net reserve deficiencies among the top-thirty global property casualty carriers.

This suggests the industry may be entering a new ‘danger phase’, as carriers continue to release large amounts of reserves even though accident year experience indicates that redundancies are fast diminishing.

Structured products

There is good news, however. Uncertainty around reserve adequacy, together with interest rate and inflation risk, can be hedged by the strategic use of reinsurance.

For example, structured reinsurance transactions can relieve long-term capital requirements for casualty lines in a low-return underwriting environment. With new investments generating less than a 2 per cent yield, the opportunity cost is very little, if any at all.

Structured reinsurance allows insurance companies to ‘keep the powder dry’ until times improve without having to shed their low return on equity portfolio.

Once the market turns, insurance companies will have the benefit of not only having additional capacity available to deploy – via the already agreed structured reinsurance – but they also will have a captive renewal book, and will not have to put time and resource into reacquiring business.

Working layer excess of loss reinsurance also provides a useful hedge. In a rising interest rate environment, medical inflation in excess workers’ compensation layers has historically been pushed significantly higher than underlying interest trends. Evaluating these layers based on overlaying medical inflation trends would be prudent.

Download this Risk Perspective article.

For more information, please contact Gregg Holtmeier on +1 415-930-9077 or email gregg.holtmeier@jltre.com.