Interest rate risk for insurance companies is a significant factor in determining profitability. Although rate changes in either direction may affect its operations, an insurer's profitability typically rises and falls in concert with interest rate increases or decreases.
Changes in interest rates can affect the assets and the liabilities of an insurance company. Insurance companies have substantial investments in interest-sensitive assets, such as bonds, as well as market interest rate-sensitive products for their customers.
Drops in interest rates can decrease an insurance company's liabilities by decreasing its future obligations to policyholders. However, lower interest rates can also make the insurance company's products less attractive, resulting in lower sales and, thus, lower income in the form of premiums that the insurance company has available to invest. The net impact on the company's profitability is determined by whether the decrease in liabilities is greater or less than any reduction in assets that is experienced.
Lower interest rates can also negatively impact an insurance company's risk profile as an equity investment if analysts believe the company may have difficulty meeting future financial obligations. Lower levels of equity investment mean lower levels of assets for insurers.
While the precise effect of interest rate changes on a specific insurance company may be uncertain, historical analysis shows that the overall trend is for the profitability of the insurance sector to increase in an environment of rising interest rates. Overall price-to-earnings (P/E) ratios for insurance company stocks usually increase in fairly direct proportion to increases in interest rates.