Timing the Increase in Interest Rates

As insurance companies focus on strategies to maintain the net investment income levels of the past, the low interest rate environment remains one of the primary concerns. Across the nation, companies are reducing product growth rates and altering product design in order to adjust to the book yields offered by the market. Low interest rates affect all insurance companies. However, a deeper look reveals that the impact can differ from one company to the next depending upon product mix and the current portfolio. Risk reduction for an insurance company is dependent upon diversification as it pertains to adjusted capital levels and investments that are properly aligned with the products sold by the insurer. Companies with shorter products or higher annuity mixes are clearly experiencing accelerated declines in book yield if they are maintaining their risk profile.

With interest rates low, the common perception is that rates should not fall much lower. This reasoning often causes some companies to attempt to “time the market” and shift their assets short versus the liabilities in order to increase book yield when rates improve. In fact, some companies have been doing this for several years. Interest rates are near historically low levels and at some point they will cycle back up; however, the timing of this event is clearly difficult. In fact, history indicates that 95% of professionals lose when attempting to time the market. Additionally, insurance companies are not in the business of timing, and focus must remain on providing for the policy holders (or members) while limiting both market risk and reinvestment risk. Over the last few years, insurers that were mismatched to their products on the short side have experienced declining book yields. These declines have been to a much greater degree than that of their competitors employing a strategy of insurance risk reduction through alignment with product liabilities. Of course, companies must also guard against shifting long versus the liabilities in order to gain book yield. This would increase market risk should rates rise. This is only one brief example of why companies need to have appropriate assets compared to the products of the company.

There will certainly be an increase in interest rates; however, the timing is unknown and complicated by the vast amount of government involvement. Currently the pressure is aimed at keeping rates low or even reducing them. Residential mortgages were the leading catalyst in the recession and many fear that commercial mortgages could be the next market issue to occur. The current desire is to keep rates low as many CMBS securities have interest resets that occur five years after issue. A large amount of CMBS product was issued in 2005, 2006 and 2007.

As stated, we do not know what interest rates will do, and because of that we are not making bets. Rather, it is prudent to properly immunize asset and liability cash flows in various interest rate scenarios. By properly aligning a portfolio over time, slow and methodically, portfolio yield should be more constant and likely increase over time.

Disclosures

Parkway Advisors, L.P. is an investment advisor registered with the Securities and Exchange Commission offering investment management, consulting, and accounting and reporting services. This material is for your use only and has not been independently verified and thus we do not represent that it is complete and should not be relied upon as such. The opinions expressed are our opinions only. Past performance is no guarantee of future performance and no guarantee is made.

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