I imagine when America's latest President-elect sounded the horn for higher US interest rates, global investors cast around for a way to win from the change.
Insurers like Insurance Australia Group Ltd (ASX: IAG) and QBE Insurance Group Ltd (ASX: QBE) must have stood out like diamonds in the rough.
After all, what could be better than IAG, with assets of $13 billion, and 84% of these in fixed-interest securities (e.g. bonds) and cash? Sounds like a sure-fire winner from higher interest rates to me.
It's not quite that simple
Many bonds pay a 'fixed flat rate coupon' that is above the rate of central banks' rates at the time the bond was created. As interest rates go up, the value of these bonds generally falls. This is because a bond that pays 3% per annum when the bond is created is more attractive than 10-year government bonds (the 'risk free' rate), which pay 2% at the time. As interest rates rise, the government bond rate rises, and the attractiveness of other bonds fall as people are willing to pay less for them.
What's that got to do with insurers?
This area can get pretty complex fairly quickly, since there are also variable rate bonds, and a number of other fixed interest securities. However, to cut to the heart of the matter just find the paragraph in any insurer's annual report that talks about its interest rate sensitivities.
In IAG's case (according to its Investor Report FY16) from 19 August 2016 a 1% interest rate rise results in a $228 million loss to IAG's investments. This could have a big impact on the financial results. In fact, IAG has actually been a major benefactor from lower rates in recent years, with the value of its fixed interest portfolio rising $151 million last year, following on from a $167 million gain in 2015.
Total investment income contributed to approximately half ($562 million) of IAG's insurance profit ($1,103 million) in the 2016 financial year, and a slightly lesser proportion in 2015. In this way, we can see how a 1% increase in interest rates and the subsequent $228 million impact would have a big hit on IAG's stated profits– which is often what the market, with its price-to-earnings (P/E) ratios, fixates on.
Over the long term, this may balance out. I couldn't find specifics in IAG's report, but like its listed peers it may aim to hold a majority of its bonds to maturity. This means that a 'face value' loss is just that, only a loss if sold before maturity.
Foolish takeaway
The interest that IAG will earn on its bonds and cash deposits will rise as interest rates rise – there's no question about that. Readers need to be aware however that the nature of bonds could see IAG wearing some ugly losses on the value of its investment portfolio (as compared to the income from said portfolio) when interest rates start to rise. IAG will also have to pay more interest to holders of its capital notes and convertible preference shares. Higher interest rates aren't a clear win-win for insurers.
