Insurers’ investment income, already suffering because of low interest rates, faces being hit again when rates rise. How can they cushion the blow?
As the recent raft of annual results shows, most companies are reporting diminishing investment returns because of persistent low interest rates.
While insurers’ core business is underwriting, they make a significant portion of their profit from investments. For example, the bulk of RSA’s £310m UK operating profit was its £270m of investment income, with underwriting profit accounting for £40m.
However, insurers will suffer another hit when interest rates rise from their current all-time lows. Most of their holdings are in government bonds and high-rated corporate bonds, and the value of these holdings will drop if rates rise.
Underperforming bonds
“If there is a 100 basis-point rate rise, government bonds and credit will underperform on an absolute basis because of the interest rate risk embedded in those securities – if rates rise, the price falls,” says asset management house BlackRock’s head of global financial institutions David Lomas.
Insurers are understandably reluctant to step outside of their investment comfort zones – many have had fingers badly burned by trying to be too adventurous on the asset side of their balance sheets.
However, Lomas believes there are several asset classes which, if invested in cautiously and in moderation, could help them weather rate rises. (He suggests that non-life insurers can comfortably invest between 2% and 5% of their portfolios in riskier assets).
1. Emerging market debt. “The risks inherent in emerging market debt are not just credit and duration, it is political, economic, currency and so forth. Emerging market debt performs better on average than traditional asset classes.”
2. High-yield debt [aka junk bonds]. “High yield performs well but very much selected names and selected positions only. Caveat emptor: make sure you know what you’re buying.”
3. Bank loans: “Bank loans have a very specific technical structure which is positive for a rate rising environment. They reset their coupon [the interest paid to the bond-holder] on a quarterly basis based on three-month Libor, so as rates rise you start to take that higher coupon as Libor rises.”
4. Equity dividend [funds comprised of the stocks of large-cap, dividend-paying companies]: “Equity dividend at the moment is yielding 3.5% to 4%.The strategy we run has a beta of 0.7, which means it has a lower volatility than the index. This is attractive for volatility management, which is key for insurers.”
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