ok so I know that insurance companies have signficant interest rate risk: from both the premiums and the payouts that they have to pay. Could someone explain why? Am I correct in the below? There’s also interest rate risk due to the assets held: predominately bonds. Due to the large duration of these assets they have interest rate risk risk, but also reinvestment rate risk too. So is this why the preimums have IR risk, because the premiums are invested in bonds? And then because the payouts are known, the liability of these is the PV of the future payouts with the discount rate being affected by interest rates? Also another question on insurance companies, just to get my head around it. Am I correct in thinking that the premiums invested in securities belong to the policyholders and then the surplus belongs to the shareholders? And the only way to increase the surplus is through any excess return made over and above that required for the liabilities?
Each month/quarter etc. a rate is credited to liabilities. Basically a return on the liability they have to pay. That rate will be dependant on the overall level of interest rates. As interest rates go down, the rate credited goes down. That’s a positive impact for an insurance company (pay less). So when IR increase, the rate credited to liabilities increases. Using mortality tables, is it relativley easy to determine the duration of the liabilities. The easiest way to mimic this liabilitiy is with bonds. Therefore, the premiums paid in are invested in bonds. When IR decrease and Insurance companies buy bonds, the yields they are getting decrease. When IR increase, the opposite happens. So when IR decrease, rate credited to liabilities decreases, and rate earned by bonds decrease. When IR increase, rate credited to liabilities increase, and rate earned increases. For each change in Interest rates, the assets and liabilities move together. If bonds are paying 5%, but the rate credited to the liabilities (whats owned by the policy holders) is 4%. That 1% difference is income that is now the companie’s money. That 1% is also known as the net spread. That was longwinded and I hope made sense.
Makes sense tks!