Jake Meyer: The outlook for long-term interest rates, in particular the prospect of "low-for-longer" interest rates should be at the forefront of insurance investors' minds.
Low interest rates have important implications for the investment returns earned on assets invested by insurers to meet future claims.
With interest rates already at low levels (10-year Treasuries are around 160 bps at the time of writing), and our expectation that they will remain low for the longer term, the insurance industry - which predominantly invests in long-dated fixed income securities - faces an operating earnings challenge.
Weakening investment returns will need to be offset by stronger underwriting results. Life insurers are most exposed to this interest rate risk given their large investments in long-dated securities.
“Low interest rates have important implications for the
investment returns earned on assets invested by insurers”
What's behind the "low-for-longer" scenario? As the COVID-19 recovery boom ends and economic conditions tighten, we expect renewed pressures – both structural and cyclical - to keep long-term real interest rates lower for longer.
Structural pressures will likely weigh on long-term rates in the medium term, and the current effect cyclical upward pressure on rates is likely to start wearing off in mid-2022.
As 2021 continues, cyclical conditions look increasingly like a classic case of economic overheating: monetary stimulus throughout the pandemic has added 36% to (M2) money supply, while fiscal stimulus has exceeded USD 5 trillion.
“With economic conditions broadly normalising, long-term interest
rates will likely start to ease starting around the middle of next year.”
With goods consumption well above pre-pandemic trends, and global supply chains adversely affected by continuing Covid setbacks (particularly in east Asia), demand pressures are feeding through to price increases.
These price increases are currently adding upward pressure to long-term interest rates. However, we expect excess demand from fiscal stimulus to roll-off in mid-2022, and that temporary upward price pressures (eg, from supply disruptions and shipping cost increases) will revert at around the same time.
With economic conditions broadly normalising, long-term interest rates will likely start to ease starting around the middle of next year.
Around this point we expect structural factors such as demographics, long-run growth rates, and debt loads to make for a prolongation of the low for longer rate environment.
Jake: With the market appearing to be overly optimistic in pricing of rate hikes the belly of the yield curve may be attractive in terms of the outlook for yields.
Currently, the market is pricing in several rate hikes in 2022 and continued hiking into 2023. A slowing of this schedule would likely see yields of these maturities fall, as the market reprices the hiking schedule.
With the front and belly of the curve quite steep at the moment, a flattening of this portion of the curve would implies a potential mispricing offering an opportunity for investors.
If markets are incorrectly pricing in inflation rates in the second half of 2022 and 2023, investors can position themselves to take advantage of mispricing through inflation-linked securities.
“The Federal Reserve flagged the life insurance industry as particularly exposed
to low rates because of leverage and maturity mismatches.”
Further, the dynamic of slowing growth, and falling inflation and interest rates, is likely to present opportunities in area of the equity market that are particularly sensitive to inflation, growth, and/or interest rates.
With investors expecting lower returns in the "lower-for-longer" environment, asset managers are likely to search for yield in higher-risk securities (e.g. emerging markets). While this can improve returns, when done across the industry it adds systemic risk to the sector.
In its November Financial Stability Report, the Federal Reserve flagged the life insurance industry as particularly exposed to low rates because of leverage and maturity mismatches, and this could add impetus to the search for yield into higher-risk assets.
