A.M. Best believes insurance companies should consider how their investment portfolios would respond to a sudden interest rate spike.

While there is the risk that the low interest rate environment will continue, the insurance ratings agency said fixed income securities tend to dominate insurers’ investment portfolios, and as yield spreads and bond prices move in opposite directions, a sharp rate rise would mean that unrealised gains accumulated during the years of a low-rate environment would suddenly become unrealised losses.

Companies adjusting their business models in response to the extended period of low interest rates could be disproportionately disadvantaged if rates suddenly move upwards, according to A.M. Best.

In particular, A.M. Best notes that life insurers and reinsurers, with their longer duration products and assets, would struggle following an interest rate spike as they would need to wait for assets to mature before being in a position to reinvest and take advantage of the higher rates.

Also, a rapid rise in rates could tempt policyholders to switch to other products that offer higher returns.

Liquidity weakening

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The resultant increase in surrenders could weaken the liquidity and financial profiles of some insurers if they are forced to realise the losses on their bond portfolios. Non-life companies could react more quickly, but it would still take some time to adjust their investment portfolios, said A.M.  Best.

The low interest rate environment has already continued for a much longer period than many observers had predicted, with a growing concern that this might be the “new normal”. If so, A.M. Best notes that this would have significant implications for the profitability, solvency and business models of insurers.

In the life sector, those insurers with large government bond portfolios and high guarantees to policyholders are most at risk.

A.M. Best said German life insurers are particularly vulnerable, as high guarantees are a feature of the market and the fall in German government bond rates has been particularly pronounced, with Germany becoming the second G7 nation after Japan to issue 10-year bonds with a negative yield.

High guarantee rates are capital intensive under regimes such as Solvency II and will become harder to service over time.

Insurance liabilities

As insurance liabilities tend to have a longer duration than assets, particularly in the life sector, if interest rates fall still further, the increase in insurers’ liabilities will be greater than the increase in the value of assets. This will have a negative impact on solvency under regulatory regimes such as Solvency II, where there is market consistent valuation.

Net profits, and ultimately capital through retained earnings, will be affected by a fall in net investment income as cash flows from premium income and maturing investments are re-invested at lower rates. This may be offset, at least initially, by unrealised gains on bonds flowing through the income statement.

A.M. Best said life and non-life insurance companies are already pursuing a number of investment changes in response to ongoing challenges.

These include more closely matching their assets and liabilities, taking on more credit risk or increasing duration.

Also, alternative investments such as infrastructure, commercial real estate and direct lending may boost returns. But higher risk assets will attract higher capital charges from A.M. Best within its capital model (Best’s Capital Adequacy Ratio) and under regulatory regimes such as Solvency II.

In a report, A.M. Best said: “The impact of product and investment adjustments will take time. How rapidly insurers are able to adjust their books of business will depend on the existing business models and regulatory constraints. While it is difficult to see the pockets of opportunity, insurers are in a position to take advantage of favourable pricing to refinance debt and lower their cost of capital.”