Inflation and interest rates are the two top economic buzz words of late, and they may have some effects on the insurance industry, either directly or indirectly.
Whether it is because they are impacting the value of the insured asset, or because they are making a difference in the insurance company’s balance sheet, interest rates and inflation really can affect the policies people buy and how much they pay for them.
Insurers are Investors
When a policyholder writes a premium check, that check is broken into different pieces by the insurance company. How those pieces are allocated depends on what type of policy it is.
For all policies, though, part of the premium goes to pay for the risk — to pay for payouts and claims. Part of the premium goes to pay for the insurer’s overhead costs — the expenses of running a business. But part of the premium is also invested in the equity market — stocks, bonds, and other investments.
Those investments, when they yield good returns, help subsidize the other two categories, and help bring down the cost of insurance. By their nature, insurers tend to be very conservative investors, mostly investing in bonds, which tend to have more stable and predictable returns over time.
Analysts tend to use the 10-year Treasury bond as a quick proxy against which to compare the investment portfolios of insurers. And while insurers surely do purchase 10-year notes, in actuality they are probably also chasing higher yields through slightly risker vehicles, such as municipal and corporate bonds, and even some lower-risk stocks, especially historically stable ones that emphasize dividends.
In an environment of rising interest rates, insurers have the option of rebalancing their portfolios because higher rates will not be as difficult to find. As rates go up, the least-risky investment — Treasury bonds — will be more likely to be the preferred investment over other investments that are perceived to be riskier. That means insurers can guarantee their longer-term rate targets, and ratings agencies won’t look at their portfolios as quite so risky.
Looking at some historical analysis, rising interest rates often lead to increased profitability for insurance companies. And with better profitability, certain policies may be able to be written with lower premiums.
Perhaps the most interest-sensitive insurance products are retirement products and life insurance.
Insurers offer some retirement products, such as annuities, and those products are sold with the primary stated benefit of having a guaranteed annual rate of return. Insurers take the premium and use part of it to pay out expenses, but then invest the other portion in funds that will be most likely to grow over the long term. They use those proceeds to pay out those guaranteed returns.
As interest rates go up, it is easier for insurers to find safe vehicles, such as Treasury bonds, to purchase and guarantee those long-term returns.
Cash value life insurance is another insurance product that relies on long-term guaranteed returns on investments.
Cash value policies, or as they are more commonly known, permanent life insurance, have a death benefit that is equal to the policy’s face value. So, if it is a $1 million policy, at the time of death, the policy will pay out $1 million. But they also have a “cash value” component that grows during the life of the policy.
Term life insurance policies do not have this cash value element.
If someone surrenders a cash value policy early, they keep the cash value that has accumulated even though the life insurance policy is closed. Alternatively, policyholders can keep the policy in place and then borrow against that cash value, which would be deducted from the face value if the policyholder ends up dying before the loan is paid back.
The cash value also serves to reduce the long-term cost of insurance for that policyholder, so if the policyholder is 50 years old and has $500,000 in cash value on a $1 million policy, then the insurance company only needs to insure that person for $500,000, where as if the person just purchased the policy, the company would be on the hook for the entire face value.
A policy’s cash value grows in different ways depending on how the policy was written. Whole life policies are written with a guaranteed rate of growth set when the policy was put into place. Universal life policies, on the other hand, grow depending on current market interest rates.
So, from a universal life policyholder’s perspective, a rising rate environment is good because that means their cash value will grow faster.
But for term policies and whole life policies, the insurance company will use the rising rate environment to purchase safer long-term investments, but nothing will change in terms of premium or from the policyholder’s perspective.
Property and casualty insurance — policies like auto insurance and homeowner’s insurance — is not nearly as affected by interest rates. There is still a portion of the premium that is invested, but since these contracts tend to be year-long policies rather than 20 years or more, long-term interest rate changes just don’t have the same impact as they do on life insurance policies or annuities.
That said, today’s higher interest rates are being driven by the Fed’s fight against inflation. And inflation is surely an issue property and casualty insurers, and policyholders for that matter, need to be aware of.
When it comes to homeowner’s policies, inflation drives up the price of homes. Higher home values translate into bigger payouts by insurers in the case of a catastrophic loss. And with bigger payouts comes higher premiums.
Conversely, while inflation may be driving up home prices, higher interest rates tend to put a cap on home values, because the interest portion of a mortgage takes up a bigger chunk of the payment, cutting into the homebuyer’s affordability.
Taken together, interest and inflation present a mixed bag for homeowner’s insurance.
Policy limits may come into play, though. Many policies put limits on things like jewelry and electronics. So, if inflation drive the values of those underlying assets up, policyholders would do well to make sure their valuables are still properly insured and within the policy limits.
Auto insurance is affected by inflation the same way as homeowner’s insurance is. As auto values go up, the price to insure them goes up as well, but the rising interest rates may cut into the affordability of the highest-valued vehicles because the loans to buy them are more expensive. Similarly, since the cost of all vehicles has been going up, state minimum limits on liability policies may not cut it if a policyholder gets into an accident with an especially expensive vehicle.
During tumultuous times, predicting the future for pricing is precarious, especially when the unknown variables are things like inflation and interest rates. But, during the current rising-interest-rate environment, there could be some challenges, but also some opportunities when it comes to insurance.
In terms of life insurance policies, now could be an opportunity to find better values in cash-value policies, and from an insurer’s perspective, an opportunity to readjust the risk profile of their balance sheet to favor less-risky Treasury debt over other riskier assets.
It is also important to note, however, the most popular type of life insurance — term life — is driven much more by risk factors and demographics than it is by interest rates or inflation.
For property and casualty policies, premiums in the short term are likely going to be driven less by interest rates, and really, not even so much by inflation, as they are going to be driven by risk and losses. Climate-change-driven natural disasters such as wildfires, floods, and hurricanes promise to be bigger drivers for property and casualty policies than other macro-economic factors.
For policyholders, now presents a good opportunity to find the best pricing by shopping around with multiple insurance carriers. Shoppers should also make sure they are buying the appropriate amount of insurance — neither underinsuring, nor over insuring, keeping an eye on asset values and policy limits in the inflationary environment.
Michael Giusti, MBA, is a senior writer and analyst for InsuranceQuotes.com