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Opus News & Insights

Income Needs Have Insurers Looking for Rate Action
Monday, September 19, 2016

We thought that it would be interesting to look at how the ultra-low interest rate environment has impacted the portfolio income of one particular insurance company, as it provides a window into what has occurred across the industry more broadly.  The below example is a holding in our Small CapValue strategy, a stock that we will call, “Company A”. 

Check out the following table:

opus capital management

Notice that over the period, portfolio income (column 2) declined from $122M to $100.8M, even though the portfolio itself grew by almost 50% (column 3). Of course, this result was created by a steep decline in the portfolio’s average yield, which declined by 250 basis points over the period (column 4). This is a real, tangible example of the way in which the interest rate environment has suppressed the earnings at financial firms that rely on “yield” to generate a substantial portion of their net income.

From today’s perspective, the interesting thing to consider is how an increase in interest rates would impact the firm’s total income (all else equal). Once again, we can use “company A” as an example. Using the most recent (Q2 2016) data for Company A, an increase of just 50 basis points in average portfolio yield would increase the firm’s total pre-tax income by 16%.

To understand how this adjustment would work in the real world, it is important to know the portfolio’s average duration. In the case of company A, the average portfolio duration is 5.8 years, which is up from 3.6 years just five years ago. Insurance companies have multiple critical factors to consider when making investment decisions. However, “all else equal,” this increase in duration means that the company’s portfolio is less well positioned to take advantage of a rising rate environment vs. five years ago.

Keep in mind, this post presents a limited example. In real word analysis, it is critical to thoroughly analyze the structure of both assets and liabilities. At Opus, this is something we do when assessing both individual financial firms, and as part of our broader portfolio construction process. Our goal is to carefully and deliberately balance interest rate risk across the portfolio.



 
 
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