Dr. Steven N. Weisbart, CLU, Triple-I Senior Vice President and Chief Economist
The Federal Open Market Committee (FOMC) of the Federal Reserve Board recently spelled out its objectives and strategies for at least the next several years—describing a financial framework they will maintain longer than the timeframe they typically describe. The length and parameters of this framework will have significant impact on the property/casualty industry.
The FOMC says it will hold short-term interest rates near zero, likely for several years—perhaps to 2023, quite possibly longer. Insurers don’t invest much in short-term instruments – to the extent that they do, it’s to have cash available to pay claims. They primarily invest in intermediate- and longer-term bonds and similar fixed-rate interest-paying instruments that provide steady income, which, together with premiums, covers claims and operating expenses. Insurers raise and lower premiums – partly in response to changes in investment income – to sustain profitable operations.
Because yields on these investments generally track short-term rates, the FOMC’s action will likely keep longer-term rates exceptionally low for several years more.
One signpost the Fed will use to decide when to raise rates is when inflation, as measured by the Personal Consumption Expenditure (PCE) deflator, is sustained at over 2 percent such that the average inflation rate including recent years equals 2 percent. To appreciate what this means, consider Figure 1. It shows that, since 2012, the PCE deflator has been below 2% (vs. same month, prior year) most of the time. The average over this span was 1.40%. But the Fed might not go back that far to calculate its long-run average. For example, since 2017 the PCE deflator averaged 1.69%. If the deflator averages 2.4% from now through 2023, the average from 2017 through 2023 will be 2.01%.
Rates falling since the 1980s
Based on the FOMC’s new framework, intermediate- and longer-term interest rates will, at best, remain at their current historically depressed levels for several years. One consequence of this is that bonds insurers hold to maturity and roll over will be reinvested at lower rates than they currently yield.
Prevailing interest rates have been generally falling since the early 1980s. Figure 2 shows this decline since 2002, as proxied by the yield on constant-maturity 10-year U.S. Treasury notes (the blue line), and its effect on the portfolio yield for the P/C insurance industry over the last two decades (the gold bars).
P/C insurers invest mainly in bonds, but not just U.S. Treasury securities. They also invest in corporate and municipal bonds, both of which generally yield higher rates than U.S. Treasury bonds because they are riskier. Yields on corporate and municipal bonds will likely loosely track Treasury yields.
P/C insurers also receive investment income from dividends on common and preferred stock they hold. These dividends are likely to be affected by corporate profits, which might be depressed for at least as long as the current recession lasts.
A shift to shorter maturities?
How will the insurers respond to these persistent conditions? If recent behavior is any guide, they are likely to shift to shorter-maturity bonds to retain the flexibility to switch back to longer-term, higher-yielding investments when rates eventually rise again. Figure 3 shows this pattern of shortening maturities during the years since 2009 as prevailing rates fell. From 2009 to 2019, the percent of bonds with one-to-five-year maturities rose from 36% to 41%, but those with 10 or more years of maturity fell from 19% to 11%.
What’s notable about this strategy is that – since shorter-term bonds yield less than longer-term bonds – the shift results in an even lower portfolio yield than the industry would have achieved if maturities were unchanged over this time span. It sacrifices near-term opportunities for the flexibility to eventually seize longer-term gains.
If the insurers continue this strategy, the shift to shorter-term bonds, combined with continued low interest rates, could lead to a scenario over the next five years that looks like Figure 4, which includes 2015-2019 yields for historical context.
Of course, future portfolio yields might be different from this scenario. For example, insurers might realize significant capital gains or losses. The portfolio yield in 2012, for example, was nearly two percentage points above the U.S. Treasury 10-year yield that year due to realized capital gains.
On the other hand, if interest rates rise, low-yielding bonds that are available for sale would suffer unrealized capital losses, which would be a direct reduction in policyholder’s surplus.
In a typical year the industry posts capital gains of $5 billion to $10 billion, but any number outside this range would affect the portfolio yield for that year. Capital losses also could result from investments affected by bankruptcies or other business setbacks caused by the recession. Impaired bonds would have to be accounted for on the balance sheet.