Finding P&C Investment Mojo after a Decade of Lost Income
Key Takeaways
The low interest rate environment will continue until nominal GDP growth rates increase from current levels.
Even in this low-interest rate environment, P&C shareholder and policyholder surplus values can be enhanced without compromising financial strength.
Macro Outlook
The past decade of low interest rates has been a huge missed opportunity for many bond-heavy P&C insurance companies. As interest rates have declined, investment income has declined as well. Consequently, the heavy burden to earn good returns on capital has fallen on underwriting operations.
It is true that a few bond-heavy companies, especially in the large cap space, have done well on the back of strong underwriting results. However, many P&C companies have earned very poor returns on capital over the past few years. This is especially true for small cap companies. Moreover, many large cap companies with excellent underwriting results could have done even better if they had obtained better investment results from their investment portfolios.
Many in the P&C industry have ascribed the low interest rate environment to market manipulation of interest rates by the US Federal Reserve (Fed). According to this viewpoint, the Fed has been following an ultra-easy monetary policy over the past 10 years, and that without this policy, the interest rates would be much higher. This is an erroneous viewpoint and acting on this viewpoint would have caused an adverse impact on investment income over the past decade. Indeed, waiting for the Fed to normalize interest rates has been a long wait in vain.
To see why this is so, let us go back in time to the 1970s, a period we associate with high inflation. At that time, many believed that the high interest rates were a sign of tight monetary policy. Yet the average nominal GDP growth rate in the 1970s was 10.6% per year. Contrast this to the average nominal GDP annual growth rate in the 2009-2019 period of about 4%.
The reality is that the Fed was actually following an easy monetary policy in the 1970s, and this resulted in higher nominal GDP growth rates, which in turn led to higher long-term interest rates. It was only when the Fed tightened monetary policy in the early 1980s that nominal GDP growth rates and long-term interest rates eventually started declining from high levels.
Similarly, the low long-term interest rates that we have been observing over the past 10 years are a result of the Fed’s somewhat tight (not easy) monetary policy. The tight monetary policy has led to relatively low nominal GDP growth rates, which in turn has led to low long-term interest rates. As further evidence of this, consider the figure below, where three observations stand out.
1. Had Fed policy been easy, nominal GDP growth rates (in green, right axis) would have been higher than the average of about 4% annually that we have observed in the recent past.
2. Long-term interest rates (in blue, left axis) are highly responsive to changes in nominal GDP growth rates.
3. The Fed attempted twice --- in early 2016 and late 2018 --- to tighten monetary policy by raising short-term rates (in red, left axis) when nominal GDP growth rates were decreasing. Both attempts were successfully resisted by the market, which responded by pushing long-term interest rates down. Indeed, in response to decreasing nominal GDP growth rates, long-term bond yields started their descent in November 2018, well before the Federal Reserve reversed course and eased monetary policy by implementing interest rate cuts in mid-2019.
Low long-term interest rates are NOT a result of easy monetary policy
The bottom line is that the market has been signaling via low long-term interest rates that the Fed’s monetary policy has been tight.
During times of panic and stress (e.g., financial crisis, coronavirus pandemic), the Fed has appropriately taken very bold steps and has eased monetary policy enough to take the most pessimistic depression scenarios off the table. However, in the recovery phase, the Fed has not followed through: monetary policy has not been easy enough to let the economy escape from the low interest rate environment.
Without getting into the weeds of monetary policy, one way by which nominal GDP growth rates and long-term interest rates could increase is if the Fed were to commit to an easier monetary policy. For instance, a credible commitment to keep short term interest rates at low levels even if inflation were to temporarily go above 2% would result in an eventual increase in nominal GDP growth rates and long-term interest rates. Conversely, attempts by the Fed to increase short-term rates when nominal GDP growth rates are low will be defeated by the market, which will push long-term interest rates down in response.
What this Means for Insurance Executives
The lesson for P&C company CIOs and CEOs is that the low interest rate environment will continue until the nominal GDP growth rates increase from current levels. For CIOs of bond-heavy P&C companies, the question is: how do you position your investment portfolio in such an environment? Portfolios stuffed with bonds will yield very low returns if interest rates stay low for an extended period of time. On the other hand, a CIO contemplating a move to add stocks to the portfolio must contend with the higher risk of significant market volatility and the potential for sharp stock market declines.
There is a way to improve portfolio returns in the low-interest rate environment without compromising financial strength. It is an approach that allows for the possibility that the low interest rate environment could be with us for some time, yet is also alert and flexible enough to alter strategy in response to changes in the macroeconomic landscape. The CIOs and CEOs that pursue this strategy will see their investment returns improve appreciably, thus significantly enhancing shareholder and policyholder surplus values.