2023 Insurance Outlook

The year 2022 was a challenging one for the bond market in the United States. The Federal Reserve's decision to significantly increase interest rates, aimed at controlling inflation, resulted in the worst total return performance for the bond market since the inception of the Bloomberg Aggregate Index in 1977. This period also marked the first time in this index's history that both stocks and bonds recorded negative returns in the same calendar year.

Despite these challenges, such market dislocations often present unique opportunities. The bond market selloff in 2022 has potentially opened a window for insurance investors to secure attractive yields in both traditional and alternative fixed income markets, which could enhance investment income for years to come.

Investment income is a critical driver of earnings for insurers. Although the 2022 selloff negatively impacted insurance companies’ unrealized gain/loss positions, the higher reinvestment yields that ensued are expected to boost their investment income going forward. This trade-off is generally viewed favorably by most companies, given the significant role of investment income in the insurance industry.

Insurance companies primarily earn income through underwriting and investments. Historically, the property & casualty insurance sector often incurs losses in underwriting but gains in investments. For example, from 1979 to 2003, the industry recorded underwriting losses every year, despite its primary goal being to earn more in premiums than it pays out in losses and expenses. High interest rates during that period made these underwriting losses manageable, underscoring the importance of investment income.

The current financial landscape presents near-term opportunities for investors. It's crucial to consider both Treasury yields and credit spreads and their interplay. As of 2023, spreads have tightened due to limited supply, while Treasury yields have decreased amid growing recession fears. However, a shift is anticipated, with both spreads and rates expected to rise in the near future. Eventually, as recessionary risks intensify, these may begin to move in opposite directions, with spreads increasing and Treasury yields falling due to rate cut expectations. This scenario provides a timely opportunity for insurers to lock in high all-in yields, enhancing their portfolios for years ahead.

As of now, market yields, as indicated by the Bloomberg U.S. Intermediate Aggregate Bond Index, stand at around 4.5%, nearly triple the level at the start of 2022 and having peaked at 5.1% in October 2022.

Insurers are also adapting to this higher interest rate environment, which has led to increased insurance claim severity across all business lines. Companies are categorized into four groups based on their ability to capitalize on these higher yields: those unable to reinvest and forced to sell bonds at a loss, those unable to reinvest but not forced to sell, those able to reinvest all cash flows to improve average book yield, and those able to reinvest and additionally harvest losses for reinvestment at higher yields.

Furthermore, alternative investments like private credit, real estate, and infrastructure continue to garner interest from insurance investors. Even though yields in core fixed income are now more attractive, these alternative assets offer additional spread and enhanced expected returns. Insurance companies are increasingly comfortable with the risks and complexities of these investments, recognizing their diversification benefits and downside protection, especially during recessionary periods. The performance of these asset classes in 2022, with their lack of correlation to traditional investments, has benefitted more diversified portfolios.