For those who don’t know me, my name is Andy Taylor. As the Chief Financial Officer for Gore Mutual, I’m responsible for the company’s finance functions including reporting, investments, reinsurance, strategic planning, and analysis and risk management.
In January, Canadian Underwriter magazine wrote about how insurance rates impact Canadian insurers and reached out to me for a comment. You can read their article here. While answering their questions, I started thinking about how our industry has managed through a low interest rate environment and thought about interest rates beginning to increase as well. I had more that I wanted to share and figured what better place to do so than our own Go Magazine!
So here are my thoughts.
The insurance industry has been significantly impacted by a period of prolonged low interest rates in the wake of 2008’s global financial crisis. This has been sustained because of a slow global recovery, unconventional monetary policies and continued economic and geopolitical uncertainty. After almost a decade of low interest rates, the most obvious direct impact on insurance companies has been a reduction in investment income from fixed income portfolios which make up the majority of P&C companies’ traditional asset mix.
There were also a number of indirect implications – both positive and negative – of the sustained low interest rate environment given that insurance companies’ return on equity (ROE) comes from a combination of underwriting profit and investment income. The reduced investment income meant that companies needed to improve their underwriting profitability to achieve similar returns as they had in past periods where interest rates were higher. Depending on the size of a company’s investment portfolio and surplus, combined ratios needed to improve by 2% for every 1% percent of lost investment yield. For most insurers, the impact of a 1% reduction in interest rates resulted in 1 – 2% reduction in ROE. This meant that as rates declined approximately 3% since 2008, companies had to find ways to improve their ROE by 3 – 6% through improved underwriting profitability and new investment strategies.
This has been particularly challenging for our industry during a period of unprecedented change in essentially all areas of the business. Advancements in pricing sophistication, business intelligence and analytics have improved profitability while investments in legacy system replacement, digital transformation and new distribution models have placed significant pressure on expense ratios and profitability.
Another approach taken by many companies has been to significantly enhance the sophistication of their investment management strategies. In the early years, this resulted in a change in asset mix to reduce the weighting of traditional fixed income and include higher weightings to other asset classes such as equities and preferred shares. These asset classes provided tax efficient dividend income, but were volatile and not capital efficient. In recent years, the level of sophistication of financial modeling has increased yet again due to continued market volatility and rising interest rates which poses significant risk for interest bearing assets, depending on their duration. Advanced portfolio theory includes modeling thousands of potential asset mix scenarios to optimize for income, volatility and capital efficiency. This has resulted in further refinement of asset mix strategies including lower allocations to core strategies such as traditional fixed income and equities, and the addition of new specialty strategies to reduce volatility while improving income.
For the first time in many years interest rates are beginning to rise. Although at the surface this is positive for the long-term investment returns of P&C insurance companies, it also poses significant risk if not managed prudently. A gradual rise in interest rates is the best scenario for insurance companies allowing them to use advanced portfolio strategies to reduce volatility while managing interest rate risk. A 2 – 3% rise in rates would return the industry to pre-financial crisis levels and overall ROEs could potentially be even higher than that due to improvements in business models and modern investment strategies.
After many challenging years of sustained low interest rates, our industry welcomes the outlook of higher interest rates and improved investment income. At Gore Mutual, we’re an ambitious growing company, transforming our business into a modern mutual. We’re investing more than ever in technology, products and pricing to help our brokers continue to succeed. Having more interest income to work with allows us to do this and invest in other initiatives that will benefit our brokers, customers and communities.