Sector and Sovereign Research has an interesting take on the importance of investment income (or, these days, the lack thereof) in insurance pricing:
For most investors, this is truly a no-brainer: lower yields mean pricing must go up, full stop. For managements, the issue is more complex, and it is not at all clear that insurance buyers will accept price increases driven [for] something that they can credibly argue is not their fault.
What might be different this quarter is, quite simply, that enough time has passed to force insurers’ hands. In a recent piece on how inflation impacts P&C insurers, we stumbled into a broader and more interesting conclusion: namely, that insurers seem to have a “3-year lag” problem where it takes roughly three years to notice and acknowledge a change in conditions, be this pricing, loss trend, or changes in market conditions. In the case of interest rates, the 3-year Treasury yield has now been between 0% and 2% for the last…three years! Insurers would likely view a more normal rate for 3-year maturities to be around 5%. Thus, we are now nearing a point where insurers may start to internalize the need to do something in response to yields that are now “permanently low.”
Backing up a bit: Insurers earn investment income between the time they collect premium and pay claims. The more investment income, the lower the premium.
I think it’s a bit harsh to think that managers suddenly wake up and realize that interest rates are low. Execs have focused pretty hard on bond yields the past couple years.
Recall, though, that in 2010, the bogeyman was inflation, which was supposed to spiral because of federal budget deficits. Management feared the income from its bond portfolio would be too meager to prop up earnings in a high-inflation environment.
Instead, rates remain low, and the bulk of a p/c firm’s securities has turned over and is earning a whopping 2-3%.
What managements really need to worry about is the spread – interest earned on securities less growth in loss trend. Until the bond portfolio has turned over, that spread is sizable. And loss trends have been benign.