Unlocking the Bank vault: How Insurers can ride the interest rate wave

Overview

Long term interest rate expectations have increased significantly in recent months in comparison to the previous low interest rate environment.

4most’s Keith Church and Dharmesh Roopun gave a talk at the recent IFOA life conference 2023 that explored the impact of higher interest rates on life insurers. This talk gave details on the expected impact on the wider UK economy, the impact on specific asset classes and how each of these elements might affect life insurers.

Impact on debt servicing costs and asset prices

The talk discussed the direct impact that higher interest rates have on households and corporates servicing their debts. Households will struggle with both high inflation and higher interest rates; however, with household balance sheets relatively healthy prior to these changes, it is expected that most people will muddle through. Corporates have seen a rise in insolvency rates, and some will see problems in rolling over their debts. Many are expected to cope with the environment but not thrive.

It is not clear that higher long-term interest rates are fully priced into some assets. Affordability is improving again for houses purchased as homes. However, house prices could fall further as, when viewed as an investment, residential property still appears unattractive. Commercial property has seen more significant falls in value already but face much greater uncertainty about their true value due to adjustments after the pandemic.

Economic precedent

The presentation examined higher interest rates in a historical context and used this lens to accurately understand the current health of the economy.

The economic environment can be compared with several instances from history where there have been sharp reversals after a period of higher bond prices. These examples of interest rate peaks can be examined to understand which are most relevant and tell us the most about the current economic climate. We can also view the current situation in the context of the long-term trend in the equilibrium real rate. The equilibrium real rate reflects the balance between demand for funds for investment projects and the savings available to finance this. This rate has been falling steadily for centuries with recent drivers including increasing life expectancy and a tendency towards saving in emerging markets.

There is no clear reason that policy rates would remain particularly high for a longer period. High inflation supports this in the short term, but markets do not expect this to last.

Impact for insurers

While insurers will be keen to observe the wider economic impacts, the talk also spent time looking at the specific impact that higher long-term interest rates might have on insurance companies.

In terms of asset management, insurers must strike a balance between chasing higher returns and matching their liabilities. In an environment where interest rates are expected to remain high, insurers may want to attract a higher relative asset return and could reverse a long-standing trend away from investing in quoted assets.

Historically insurers have been more prone to distribute dividends in a low interest rate environment in order to maintain the total shareholder return. However, dividends in general may be expected to be higher in a high interest rate environment. As such, there is no clear ideal dividend distribution strategy for insurers.

There may be a change to the relative attractiveness of offering various products. This could lead to a further increase in the annuity market or could potentially see a return to defined benefit pension schemes or with-profits product designs. The talk also discusses historical trends for M&A activities and asks how the interest rate environment may impact this.