A higher interest rate environment is in principle good news for the insurance industry, says Swiss Re Institute (SRI) in a new Economic Insights report.
At the same time, higher yields and less central bank intervention in capital markets also suggest a return to an "old normal" regime that has potentially higher bond market volatility, which makes in turn insurers' balance sheet management more important.
In the report titled “The old normal: interest rate rises signal relief for insurers' returns, but likely more volatility”, Mr. Patrick Saner, head of Macro Strategy within Group Economic Research and Strategy at Swiss Re, notes that last week, the US, European and UK central banks all raised their key policy interest rates again by at least 25 basis points (bps), reaching rates of 4% or above in the US and UK. This return to pre-global financial crisis interest rates is very welcome for the insurance industry, as investment-related income is a substantial driver of its earnings.
He says that although higher yields are expected to support insurance industry profitability, an environment of less central bank intervention is also expected to mean higher bond market volatility in the future, which could make balance sheet management more challenging.
While insurers' asset-liability management (ALM) frameworks can help to isolate interest rate risk across their balance sheets, investment income is nonetheless a key contributor to insurance companies' earnings. For example, investment income typically contributes about 30-70% of the earnings of European insurers. Market risks are also a substantial component of insurers' solvency capital requirement (SCR). The expected return on invested capital is now above 20% for fixed-income market risk, compared to medium or even negative single-digit returns in 2016.
Higher interest volatility is likely
A normalization of the yield environment, however, might also bring higher interest rate volatility in the future. Indeed, as is the case in the US, the volatility regimes before and since the US Federal Reserve (Fed) launched its bond-buying QE programme differ significantly. The Fed's intervention materially lowered volatility in the US sovereign debt market, as seen in the ICE BofAML MOVE Index, which measures the market-implied volatility of the Treasury yield curve. In contrast, the pre-QE period shows more extreme swings in yields. A monetary policy transition which means less invasive central banks in capital markets might therefore also mean higher bond market volatility in the future.