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Insurance Markets Best Practice

The Insurance Sector: Plenty of Silver Lining to Be Found

by Andrew Milligan

Executive Summary

  • Why the insurance sector came out of the downturn better than the banks.

  • The important effect the yield curve has on insurance liquidity and the real economy.

  • The need for Governments to act on a number of fronts.

  • The shift in wealth from savers to spenders.

  • The importance of not rushing to judgement on regulatory matters.


If one looks at the devastation wrought on the global finance community, there is no doubt that the insurance sector has come out of this in very much better shape than the banks. There have been casualties—AIG in the United States, for example. However, AIG was a special case, being much more of a financial conglomerate than a “pure” insurance company.

The reasons why the insurance sector has been less affected by the financial services “meltdown” are complex. An important factor is that there was no parallel to the way the banks—and the shadow banking system that sprang up in recent years—leveraged themselves. Relying on a constant supply of new funding to keep their business models running meant the eventual liquidity crunch left certain banks high and dry.

This does not mean that the insurance sector does not have issues to face in the future. It will have to deal with the aftershocks of the economic downturn, with weakness and volatility in the stock, bond, and property markets, or with movements in annuity rates, all of which will pose serious challenges.

The Shape of the Yield Curve Is Important

It is already clear that the shape of the yield curve is going to be of considerable importance in the months ahead. So far, governments have tended to implement monetary policy by urging central banks to reduce short-term interest rates. The next step in this program has been quantitative easing (QE), namely governments going out and buying certain private and public-sector assets in significant amounts, to the tune of hundreds of billions of pounds. At present, government and then corporate bonds are to be top of the shopping list.

Such QE policies could eventually flatten parts of the interest-rate structure. This may possibly have an impact on annuity rates, driving them down. Historically, the level of long-term interest rates is more correlated with the weakness of the economy than with the supply of new government bonds. Conversely, it is possible that the very sizeable public-sector debt issuance expected in the coming months and years could be skewed towards the longer end of the yield curve, as a means of keeping long-dated yields higher. We could end up with some very peculiar yield curve shapes in the years ahead. Either way, coordination between the Bank of England and the Debt Management Office in the United Kingdom, and counterparts in other countries, will be vital in the coming months.

The shape of the curve also has strong implications for the real economy. In normal circumstances, changes in interest rates have an impact fairly quickly on economic activity. However, the precise interest rate does matter. The United Kingdom may have very low base rates, but, in fact, the mortgage market is very heavily based on the level of two- to five-year interest rates. In the United States, it is the 30-year bond yield which matters more for mortgages. European companies are generally financed by a mix of medium-term bank lending and corporate bonds.

There is a major impact, of course, on savings rates. Savers are being affected by very low base rates. This produces a strong incentive for people to spend, or to invest in something other than cash. For example, it is already clear that there is a growing demand for corporate bonds. Although there are concerns about the number of companies that could fail during the recession, the high yield on good quality corporate bonds means investors buying a diversified portfolio should normally be rewarded for the risk in buying such an asset. It is the case, though, that an investor who classically needs a 5% return on his or her money, for example, to finance his or her retirement, does not have many options right now, apart from buying some corporate bonds, some equity or even some commercial property. However, an investor should note that as and when the economic recovery begins, and government bonds are likely to be sold off, corporate bonds will then also suffer, though by less than public-sector debt.

The shape of the yield curve also gives signals about investor sentiment. A singularly odd shape in the curve occurred in the United States in early December 2008. For a few days, the interest on three-month Treasury bills actually went negative, which means that buying those bills and holding them to maturity would return less than the capital sum, even before the impact of inflation is factored in. The only way to explain such negative interest rates is complete and utter risk aversion dominating the market. When people fear there is no safe haven for cash, they will take a slightly negative rate as the best way of conserving whatever possible value. As investor sentiment has recovered in recent weeks, so by the end of April, three-month US Treasury bills were paying positive, albeit at only 0.2% interest, just above US inflation running at −0.1% a year.

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