Rising bond values and inflation – a potential shock loss?

13 July 2017

The short- and long-term effect of rising bond values and inflation on the insurance industry.

Mark R Shumway, Global Head of Strategic Advisory at JLT Re 

Interest rates may be lingering near historical lows in Europe, but they are rising in the US in response to economic recovery and scattered signs of over-stimulation. 

In March, the Federal Reserve increased its benchmark interest rate by a quarter of a percentage point, the third increase since December 2016.

Meanwhile, loss costs are sharply higher in a few segments and are accelerating in many major lines of business. 

The sharp increase of long-term disability costs under a negative Ogden discount rate and the assignment of benefits issue in Florida are two of the more acute problems with which insurers are presently dealing. 

However, costs continue to rise at an accelerated pace in personal and commercial auto, A&H, and some workers’ compensation segments, among others.

Increasing interest rates

So what might this mean for insurers? Higher interest rates in isolation are a boon in the long term as insurers can earn better returns on new bond investments.
However, in the short term, insurers suffer loss of book value from the falling market price of the bonds they already hold. And, more significantly, increasing interest rates are recognition of building inflationary pressures.

We stress tested a composite of 25 large global non-life insurers, the JLT Re NL25 Index. This group collectively held $3.1 trillion in bonds at 30 September 2016. 

A modest 85 basis point (bps) rise in government bond yields – a scenario similar to that seen in the fourth quarter of 2016 – led to a 16.4% decline in equity for the composite.

Severe consequences

A more severe test of the market may have a catastrophic result. 

A two percentage point increase in interest rates combined with a seven percentage point underestimation of net loss costs would result in a severe earnings and material capital event for the sector that could result in rating downgrades, franchise value impairment, and even runoff for some carriers.

Inflation is just one of the many factors that can lead to under reserving and mispricing. 

Indeed, as an industry we cannot reliably estimate the ultimate cost of many of our products until well after they are sold. This keeps things interesting (and provides full employment for actuaries).

In this context, reinsurance should be seen as a diversifying investment – an instrument through which insurers can hedge against the risks into which they are otherwise locked. 

What is your appetite for uncertainty in loss costs?

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For further information, please contact Mark Shumway on +1 215 309 4535 or email mark.shumway@jltre.com