The Effect of Interest Rate Changes on the Profitability of Insurance Companies

Article excerpt

It is argued that a continuing decline in market interest rates tends to make it more difficult for insurance companies to provide high interest rates for their customers or insurants and-as a result-to maintain hence high levels of profitability. The present paper examines this proposition in Taiwan over a period of declining market interest rates for insurance companies. Flannery's (1981, 1983) model was used to examine the relations between changes in market interest rate and the profitability of 12 domestic insurance companies. The results suggest that the effects of changes in interest rates on insurance company profitability depend on how profits are measured, that it differs depending on the profit indicator that is employed. This result is not apparent, with there being no obvious influence of interest rates on profitability, if the entire insurance sector is considered as a whole.

1. Introduction

Since insurance companies make their promises or commitments to insurants at the time of the sale of policies to the latter, they are not free to adjust the rates fixed or agreed in the sale subsequently depending on circumstance. This feature of insurance exposes them directly to the risks associated with changes in interest rates changes. Specifically, the agreed or assumed rate is higher than the market rate, reinvestment risks will appear; whereas if the assumed or agreed rate is lower than the market rate, price risks will become the problem. Over recent years, the market interest rate in Taiwan has remained at a low level, suggesting that Taiwanese life insurance companies will be faced with reinvestment risks that they will have to be managed. How to manage such risks effectively has become an important issue for these insurance companies and one that has attracted much attention from the industry and from its regulators.

It is possible that a continuing decline in market interest rates might result in the insurance companies being incapable of meeting their obligations to their insurants, of giving them the high rates 'promised' to the latter at the time of the sale of policies to the latter. If life insurance companies 'take liberties' with their policies in this regard, without balancing the risk from interest rate changes in the future, this will impose a huge burden upon their financial operation. Not only will it strain the company's capacity to clear their debts, it will also have a negative impact on society. Life insurance companies must calculate how much interest rate risk they are and will be facing, and properly adjust their assets and liabilities, in order to maintain their capacity in this regard in the future.

2. Research Methods

The observation period of the investigation was from December, 1998 to September, 2003. The subjects of the study were only 12 institutions in Taiwan, among which there are four listed life insurance companies and eight listed P&C insurance companies. The companies in the sample were Cathay Life, Shin Kong Life Insurance, Taiwan Life, China Life, Central Insurance, Union Insurance, Fubon Insurance, South China Insurance, First Insurance Agency, Taiwan Fire & Marine Insurance, Chung Kuo Insurance and Shin Kong Insurance. The 'results' of the companies were calculated each quarter, on the basis of the companies assets in their balance sheets and their income statements. Operating income and cost were based totals in each quarter. The market interest rate used in this research is the interest rate on 90-day commodity paper. Profitability in this research refers to operating net profit, the amount left after deducting operating costs from operating income.

The study adopted the Flannery Model (1981, 1983) of the relations between changes in market interest rates and bank profitability. However, whereas Flannery ( 1981,1983) only used operating profit as the dependant variable, the present research used other profitability indices as well, namely assets return rate, net return rate, operating profit margin, operating rate of margin and net interest rate. …