We live in uncertain times and face many profound societal and economic challenges. These now include inflation, which has become a major concern for the first time in decades. Supply chain and labor market disruptions have contributed to rising prices and higher worker salaries. Economic growth coming out of the pandemic and, more recently, conflict in Eastern Europe have resulted in much higher energy and materials costs, as well as increased volatility in the capital markets.
Because of these developments, inflation seems likely to persist for the foreseeable future and is raising concerns among insurers. For property and casualty (P&C) carriers, the challenge has been more acute, with premiums lagging behind the rate of inflation, while claims costs have increased month by month. There’s also increasing awareness in all industry sectors of the potential for asset-liability mismatches and resulting implications for surpluses.
As global workforce numbers begin to approach pre-pandemic levels, some supply chain pressures are likely to ease over the course of the year. However, the political situation in Eastern Europe almost certainly will result in sustained high prices for oil and gas, many basic foodstuffs, and some vital metals and minerals. Even though they’ll reduce disposable income, these developments mean inflation is likely to remain a global concern for some time.
Against this backdrop, the US Federal Reserve (the Fed) has mulled over its response to inflationary pressures. Historically, rising inflation led to correspondingly higher interest rates, but a seemingly fragile economic recovery and initial assumptions that inflation would be short-lived led the Fed to leave near-zero interest rates in place through winter of this year. However, in line with the outcome of the January Federal Open Market Committee meeting and Chairman Powell’s comments to Congress on March 2, the Fed announced a quarterly rate hike of 25 basis points at its March 15-16 meeting. It also said it could potentially raise rates again later in the year depending on economic conditions.
Although rates remain low by historical standards, any increase has potentially significant impacts on insurers. Carriers should be aware of and plan accordingly for the ways higher treasury rates could affect:
For life and retirement providers, higher interest rates will broadly reduce reinvestment risk and make rate guarantees less expensive from an economic standpoint. However, too sharp a rise will introduce disintermediation risk, which will negatively impact balance sheets. (Carriers should keep in mind the mass lapse scenarios of the early 1980s). In contrast, a gradual change in rates will mitigate these risks, but carriers would need to reset rate guarantees and pricing more frequently than they have recently in order to respond to market pressure on book value guarantees.
In addition, higher interest rates, coupled with fluctuating equity markets punctuated by periodic crashes, are likely to make equity-indexed life insurance and annuities less attractive to policyholders. As rates rise, insurers will be in a better position to offer insured products with more substantive interest rate guarantees.
Moreover, life and annuity providers will face less pressure on the margins they earn from legacy blocks of annuity and insurance premiums with high minimum rate guarantees. With rising rates, they may offer fewer buyouts on products like fixed annuities. Conversely, we may see increased activity in blocks that were too expensive to sell under a low-interest-rate environment, given the bid-ask gap between buyers and sellers.
In contrast, P&C carriers could face difficulties with coinsurance terms. In an inflationary/higher-rate environment, coverage may not be adequate to make policyholders whole after a loss, especially a catastrophic one. Although minimum coverage is legally mandated in many cases for individuals and businesses, restitution shortfalls and correspondingly aggrieved policyholders can become problematic for carriers. In such an environment, prescient insurers will review product structure and features with underwriting and brokers to ensure coverages are adequate and go beyond legally required minimums.
Generally speaking, insurance companies will benefit from rising rates and might be in a position to increase risk premiums for standard products. Accordingly, more favorable sector returns are possible. Carriers will need to weigh return expectations against the increased options and benefits they may need to offer in order to remain competitive.
P&C carriers will face greater product pricing challenges because the generally shorter-term nature of P&C coverages means they can’t expect longer-term market trends to offset the short-term declines in the rate of return that typify inflationary periods. Although they will be able to raise premiums to a certain extent, they’ll need to rely more on underwriting efficiency and investment earnings to minimize any shortfalls between premium revenue and claims payouts. This is a difficult balancing act that P&C carriers struggled with in the last prolonged inflationary period of 40 years ago. They appear to be better prepared to deal with inflation and rising interest rates now than they were then, but investors are likely to be cautious until they see positive returns.
Rising rates typically result in a cooling of the reinsurance transaction market because insurers have less need to reinsure or transfer interest rate risks to other parties. In particular, life and annuity companies may reverse their recent course and manage legacy business risks on their own and/or potentially underwrite more new business. If so, they’ll need to weigh the benefits of these actions against their overall risk tolerances and capital levels.
An even bigger change could be how higher interest rates affect what has been a very active insurance deals market. As interest rates climb, there may be a decline in acquisitions because of higher valuation rates. There’s also the possibility of distressed credit risk as highly leveraged deals from recent years come under increasing valuation pressure. For example, leveraged multiples are not moving in line with escalated valuations, and consequently more investor capital is at risk.
However, there are many factors driving the currently active deals market and we have yet to see signs of it cooling. There are still many legacy blocks available for new and existing players who are looking for additional scale, platforms and assets. Sellers, who continue to look for ways to shed non-core businesses and blocks, remain motivated and optimistic about higher pricing and haven’t been deterred by transaction complexity or buyer profile. But, if interest rates continue to rise, then deals are likely to decline at least somewhat.
Insurers periodically assess the adequacy of assets backing reserves under various interest rate scenarios in order to identify possible shortfalls between current assets on hand and ultimate liabilities due. Life and retirement providers typically evaluate anticipated cost of minimum interest rate guarantees on life insurance, long-term care, and annuities as part of their annual regulatory reporting requirements. In the case of interest rates that rise slowly over a lengthy period of time, companies will be in a better position to pass asset-adequacy testing requirements, effectively reducing surplus strain. Conversely, a rapidly rising interest rate scenario will create strain on capital positions as asset market positions lose value faster than liability book value positions. Furthermore, rapidly rising rates could create strain on statutory balance sheets, create significant non-admitted assets, and ultimately depress risk-based capital (RBC) ratios and company ratings.
During the last prolonged inflationary period of the 1970s and early 1980s, P&C carriers saw unpredictable claims trends, poor underwriting performance and rising rates lead to fixed-income asset value deterioration. However, today’s information systems and financial reporting tools provide carriers with much better information on loss costs, thereby enabling them to recognize and respond more quickly and effectively to negative trends. Moreover, industry balance sheets and capital positions are currently quite robust. Accordingly, reserve risk deterioration would likely require several years of higher inflation to recognize adverse development flowing through earnings. Companies that maintain longer-tail casualty reserves will be more likely to experience reserve volatility in a high-inflation environment because of rising medical costs (including workers’ compensation, auto personal injury protection and other coverages) and social inflation, which leads to more litigation and larger damage awards.
All segments of the industry will face changes to their investment approaches. Higher interest rates mean the search for yield will be less challenging than it was when rates were near zero. Carriers will be able to consider rebalancing portfolios, perhaps moving back to more traditional investments and relying less on alternative asset classes.
The upside of higher yields is that insurance companies may be able to return to their traditional investment approach: duration-matched, fixed-income assets tied to specific liabilities. This conservative approach could allow companies to reduce their reliance on capital-intensive-high yield assets. In addition, with higher yields, the market appeal of “indexed” (structured equity participation) products may decline in significance in insurer portfolios because of their higher surplus-volatility implications relative to traditional fixed income.
Rising rate scenarios have statutory asset adequacy and capital implications that could result in lower required reserves in respect to minimum rate guarantees. Public companies will need to reevaluate their generally accepted accounting principles (GAAP) reserving under these new rates, especially under the requirements of the FASB’s Long Duration Targeted Improvements (LDTI).
Any effects of rate increases on corporate taxation will take some time to manifest. For non-life companies, the discount factors applied to unpaid losses are based on a 60-month average interest rate. For life companies, the interest rate used for tax reserve valuation purposes is generally the same as the rate used for the NAIC) annual statement. The rate used to test contract qualification as life insurance involves a comparison of the applicable federal rate (AFR) (also a 60-month average rate) and the NAIC Standard Valuation Law rate. That said, rising rate scenarios have the risk of creating significant derivative taxable losses that are non-admissible under statutory capital regulation, resulting in potentially significant capital depletion from deferrable capital losses.
As a case in point, some companies may experience challenges with sources of sufficient capital gain income in either the three-year carryback period to support a hypothetical refund or in the three-year realization period. In the latter case, projections of future capital gains are difficult to support and usually rely on 1) unrealized gains in the portfolio and 2) a tax planning strategy that matches capital losses with capital gains in the realization period.
If higher interest rates translate into lower values in an insurer's investment portfolio, then capital loss limitations could become significant at some point in the future. But, even though investment markets have been turbulent lately, equities have yet to experience a truly significant decline and existing discounts on bonds generally will expire if the bonds are held to maturity.
Rising US treasury rates could significantly change how insurers operate. In particular:
Additional contributors to this article include, deals partner John Marra, tax managing directors Mark Smith and Rob Finnegan, and actuarial partners Alexandre Lemieux and Marc Oberholtzer.