Persistently low interest rates

Policy rates set by the major central banks have been close to zero for about seven years. In this context, speculation over the starting point and consequences of the interest rate hike by the US Fed dominated financial markets throughout 2015. While interest rates affect all re/insurers, not all lines of business are affected to the same degree. Short-term business can usually be re-priced on an annual basis, thereby making its sensitivity to interest rate fluctuations marginal. By contrast, interest rates have a significant impact on long-term lines of business, such as life insurance and casualty products, where investment income is a significant source of earnings. Although the timing of US rate increases received a lot of attention, the re/insurance industry remains very focused on where they will end up in the long run.

While recent low interest rates are primarily connected to the financial crisis, the decline in both short- and long-term yields had already started in the 1980s. A number of economists attribute the current low yield environment not only to the financial crisis and its aftermath but also to this long-term trend towards lower equilibrium rates. This trend is associated with both a decline in real interest rates (nominal interest rates adjusted by inflation expectations), and also with lower inflation expectations. However, there is no consensus on the equilibrium real interest rate nor why it has been declining.

While a frequently mentioned determinant of long-run trends in real interest rates is economic growth, the relationship is more tenuous than widely believed. A recently published Geneva Report on the World Economy1 mentions other key factors. An ageing population in most parts of the world led to an increase in the aggregate propensity to save, some of which went into fixed income assets, lowering interest rates. Another contributing factor has been the increase in Chinese savings. The higher savings levels, coupled with China’s increased financial integration, led to large capital outflows into global financial markets. Finally a shift in investor preferences away from risky assets towards safe bonds is another likely driver for lowering interest rates.

Since these factors may persist for some time, re/insurers need to be prepared to cope with ongoing low interest rates. However, the report also mentions that, with time, interest rates could increase as the causes of the downward trend reverse. First, aggregate savings levels could decrease as the cohort of current savers continues to move towards retirement. Second, with the shift in China from investment and export-led growth to a more consumption-driven economy, the Chinese outflow of capital into global financial markets may also stabilise. Finally, a gradual return of investor confidence into more risky assets could also alleviate pressure on interest rates.

1 “Low for Long? Causes and Consequences of Persistently Low Interest Rates,” October 2015, International Center for Monetary and Banking Studies (ICMB) and Centre for Economic Policy Research (CEPR).