Across every sector of the financial services at the moment, all eyes are on interest rates, and the global P&C insurance industry is no exception. At the time of writing, global financial markets seem to hinge on any news of central bank rate cuts or hikes.
In late July, the Governor of the Bank of Japan (BoJ), Kazuo Ueda, caused a major ripple in the market when he announced an increase in interest rates to around .25% with an eye toward further rate hikes in the coming months. It was only after more dovish comments from another BoJ official in early August that global markets rallied slightly.
In the U.S., the release of key economic data points like CPI, payrolls, and unemployment have swung markets violently this summer as each bit of positive news slashed hopes of a Federal Reserve rate cut in September.
And, in Europe, the ECB has already begun cutting rates in a bid to stimulate the economy- a move which the Danish Central Bank has signaled that it will follow.
It's all over the news, but what does it mean for the insurance industry broadly and the P&C insurance segment in particular?
To understand this question better, let's briefly have a look at the role a central bank plays in the economy and how its decisions affect the financial markets and the behavior of market participants.
A central bank's main task is to act as a stabilizing force for a country's financial system. One of the key levers at a central bank's disposal is the control of the discount rate. Changing the level of this critical interest rate can have dramatic effects on borrowing costs for governments, corporations, as well as private citizens, and can thus exert a major influence on the macroeconomic environment of a country, region, or, indeed, the entire world.
When a nation's economy is slowing or in recession, the central bank may reduce the discount rate in order to make borrowing more affordable in hopes of stimulating growth, investment, and spending. While these lower rates are attractive for spenders, they are less attractive for savers as interest on savings vehicles reduces as well.
On the other hand, when an economy is growing rapidly and risking high inflation, the bank will step in to raise rates thus increasing the cost of borrowing and incentivizing saving with the aim to cool the overheating economy and curb inflation.
Operating within that economy are all kinds of companies, including insurance companies offering coverage for both life and non-life lines of business. Obviously, life insurers, with their extremely long-tail books of liabilities, are most susceptible to fluctuations in interest rates, but non-life insurers are also not immune to the direct and indirect influences of rate changes.
Directly, shifts in interest rates impact a P&C insurers' balance sheet, with the value of investments increasing or decreasing inversely to the direction of rates. The longer the duration of the investments (e.g. 10 year vs 30 year government bonds), the bigger the impact of interest rate changes. On the liability side of the balance sheet, shifts in the discount rate can have a major impact on the valuation of loss reserves. Here again, the longer the tail of these reserves, the bigger the impact. And, as higher interest rates generally correlate with higher levels of inflation, this can easily lead to a "double whammy" scenario for an insurers' balance sheet, wherein the face value of assets decreases while the value of loss reserves increase (especially if the rate of inflation is higher than the rate of return offered by interest (i.e. negative real rates), but more on this later). This situation can have a devastating effect on a company's solvency ratio.
Indirectly, interest rates play a major role in an insurers' growth prospects, financing costs, return expectations, and customer retention levels, among other factors.
As outlined above, low interest rates tend to lead to an expanding economy, and, as the saying goes, "a rising tide lifts all ships." Economic growth equates to more real estate, more cargo shipments, more cars, more smart phones, more travel, more pets etc.- all of which need to be insured.
Low interest rates also lead to cheaper financing costs due to lower return expectations from investors. This cheaper financing for insurers can be used for organic growth into new territories, product innovation, as well as mergers and acquisitions.
Higher rates, on the other hand, tend to cause the opposite effects on growth and financing costs, with additional pressure coming from customer retention. As higher rates usually correlate with higher inflation, customers may struggle to make ends meet and begin shopping for cheaper policies covering "the necessities" (Health, Home, and MTPL) and going without insurance protection on everything else.
So, with this broad understanding of how rates can impact a non-life insurance company generally, let's get more specific and look at how interest rates have affected the Danish insurance industry in recent years and have a look at what the future may bring.
With the exception of recent years, interest rates in Denmark have been in a steady downtrend since 1983 highs.
Looking at the Danish 10 Year Government Bond as a proxy for typical fixed income investment yield, we can see that rates topped out at 15.76% in August 1983 and fell to a record low of negative 0.93% in August of 2019. Since then, rates have increased sharply hitting a new multi-year high of 3.1% in September of 2023.
Though yields have risen, they have not kept pace with the rate of inflation in Denmark, which has created an environment of negative real rates (the rate of interest minus the rate of inflation) since roughly Q1 of 2018. Furthermore, yields have been extremely volatile in recent years, with their standard deviation being more than twice as high between 2019 and 2024 as they were between 2015 and 2019.
How has this affected non-life insurers in Denmark?
Negative real rates have been a headwind, as liabilities inflated higher than the discount rate. Further pressure came from the declining value of many assets due to rapidly increasing yields. The challenging macroeconomic environment weighed on growth, and the extreme volatility in interest rates also led to volatility in investment income for many insurers. On average, fluctuations in investment income were the biggest contributor to net result volatility over the last five years, and investment results were nearly twice as volatile as underwriting results during the same period.
Looking forward though, inflation and GDP growth are expected to stabilize- barring any black swan events- and central banks in Europe have already begun cutting interest rates which should incentivize further growth.
For insurers, normalizing inflation and yields should equate to more stable profits, and, even though lower rates may drag on investment income, inflation is expected to decline as well- meaning that real rates should provide break-even or modestly positive yields for the first time since before the Pandemic.
Further tailwinds will likely also come from rising solvency ratios as asset prices increase in value, and, as borrowing costs fall, an abundance of capital should be freely available to finance growth, innovation, and M&A. Indeed, the dark clouds of the past few years seem to be clearing, and, with a continued focus on strong underwriting, the near future should be relatively bright for non-life insurers in Denmark.