Interest rate risk contributes to low valuations

(Re)insurers’ flight to high quality fixed-income investments to ward off the effects of the economic crisis is creating its own risks, says Guy Carpenter global head of business intelligence David Flandro.

By piling into highly rated government and corporate bonds, (re)insurers are exposing themselves to a short-term fall in the value of bond portfolios in the event of an unexpected sustained increase in inflation and thus interest rates.

Such a capital drop would come at the same time as an increase in claims costs driven by the inflation.

Flandro said: “If inflation is worse than people expect, and interest rates go up faster than people expect, that will have an impact on the balance sheets of insurance and reinsurance companies, and we don’t think everyone is examining this.

“Part of what’s driving this is that everybody wants to buy high-grade fixed income securities, which means that companies are concentrated in this asset class and are therefore sensitive to movements in it.”

He added: “In the early 2000s, we had a stock market bubble. In the middle of the decade, there was a realestate bubble. Where do you think the bubble is now? It is a high-grade, fixed-income securities bubble.”

The interest rate risk (re)insurers are bearing as a result of their flight to quality could be one of the reasons why the industry’s shares trade at a discount to their book value and the industry might not have as much excess capital as it might seem. This, in turn, is preventing large rate reductions.

Another reason is that reserve releases are starting to dry up. Guy Carpenter has studied the SEC returns of US insurance companies. These show that the industry is on the cusp of having to start strengthening reserves. This, alongside interest rate rises, could lower capital.

Flandro said capital growth in the industry in 2011 mainly came from two sources: reserve releases and unrealised capital gains.

“Yes, there is a lot of excess capital in the sector, but we have to ask ourselves how tangible it really is.” he said.

“Some of it isn’t that tangible and that is why we don’t think we have seen a wholesale decline in rates on line. People are still quite uncertain about the true economic levels of that capital and we have also just come through a big period of catastrophes, which still has people carefully examining their risk.”