The old normal: interest rate rises signal relief for insurers’ returns, but likely more volatility

Monetary policy normalization is in principle good news for insurers, as investment income is a key driver of insurers’ earnings. Higher interest rates and less bond market intervention by central banks also means a return to a more “normal” volatility regime. Consequently, we see balance sheet management becoming more important for the insurance industry.

– The market environment for fixed income is now far more benign than even three years ago.

– Investment income is a key driver of insurers’ earnings. In Europe, investment income contributes between 30-70% of earnings.

– Monetary policy normalization might also mean a return to a more “normal”, and hence higher, bond market volatility regime.

– For insurers, we expect this could make balance sheet management more important and challenging.

After more than a decade of zero and negative interest rate policies, advanced economies are normalizing monetary policy and transition back to a “no-quantitative easing (QE)”- environment. 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. However, although we expect higher yields to support insurance industry profitability, an environment of less central bank intervention to also mean higher bond market volatility in the future, which could make balance sheet management more challenging.

In with the old

The fixed income capital market backdrop is fundamentally more benign than even only three years ago (see Figure 1). Risk free bonds are no longer return free and yields on corporate bonds have risen in turn, to offer more return for the risk. 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’s (Fed) launched its bond-buying QE program 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 (see Figure 20. 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.

A higher interest rate environment is in principle good news for the insurance industry. 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.