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Cash flow and interest rate risk: the timing of an interest rate increase is hard to predict, but when it happens, it will have important consequences for insurers.

Insurers are operating in an environment where interest rates are not only declining, but also are reaching historical lows. With U.S. Treasury yields in a downward trend since 1981, the insurance industry now has a workforce largely without experience managing companies during periods of significant rising rates.

Eventually, however, interest rates will rise, and insurers will have issues to confront. Financial forecasting models can help management prepare for eventual higher rates. While insurers may see higher rates as a relief for investment income, they may also see negative effects to their asset values as bond prices fall. While the balance sheet and income statement get the most focus in measuring interest rate impacts, it is also useful to think about the interaction of cash flow with interest rates.

Double-Edged Sword

When rates rise, the value of bonds falls (a negative effect), while the opportunity for reinvestment income in the future increases (a positive effect). Interestingly, there seems to be no consensus on which effect is more important to the value of an insurer--the immediate drop in bond values or the expectation of increased investment income. Although insurers would love to see higher investment income, seeing measurable value of higher reinvestment rates takes patience. Income may be higher in the future, but negative total return and the loss of unrealized gains are immediately painful.

A rise in rates is often accompanied by the fear of runaway higher yields and negativity toward the bond market. This will create increased selling of bonds and accelerate the upward pressure on yields. Products in which yield is a key component of pricing, such as annuities, may see an immediate benefit, but investment income can only grow as fast as a company has new cash flow to reinvest. One simple modeling tool to quantify the value of higher rates is a running investment income forecast. The forecast gives a measurable metric of the positive income effect from higher reinvestment rates.

The balance sheet and income statement provide measurement of two important values to insurers--the company book value and earnings. Cash flow affects these measurements, but can be more difficult to calculate because of timing effects that differ cash flow from income. Higher interest rates interact with cash flow to impact book value and earnings. One direct influence is that positive cash flow increases the invested asset base from which companies earn income.

One benefit of bonds as an asset class is that when an insurer can hold bonds to maturity, any value fluctuations disappear as the bond moves to redemption value. The ability to hold the bond is directly dependent on operational cash flow. Positive cash flow pays for current liabilities so bond holdings will not need to be sold. This eliminates forced sales that create an immediate mark to market through realized gains and losses. A comprehensive cash flow forecast can better measure how much the risk of rising interest rates will develop into permanent losses of capital. An insurer with positive cash flow effectively has less interest rate risk than a similar company with negative cash flow. Positive cash flow will also accelerate reinvestment into a higher rate environment, providing the further benefit of higher income.

The timing of an interest rate increase is hard to predict, but when it happens it will have important consequences for insurers. Companies do not have to be complacent while waiting for higher rates. Integrating accurate cash flow models with income and balance sheet forecasts will give a more complete picture of interest rate risk to insurance company management.

Best's Review contributor Frank Conde is chief investment strategist of Prime Advisors Inc., a Sun Life Investment Management company. He can be reached at bestreviewcomment@ambest.com.
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Title Annotation:Insight: Asset Management
Author:Conde, Frank
Publication:Best's Review
Date:Sep 1, 2016
Words:619
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