Interest rate insurance protects the holder of a variable rate mortgage or loan from rising interest rates. It is generally offered independently of the original borrowing and typically as an alternative to a remortgage onto a fixed rate.
As the insurance policy protects only against the risk of the repayments rising because of interest rates (and not of the borrower defaulting on repayments) there is no requirement for the insurer to check the credit status of the purchaser or the value of any secured asset.
The absence of arrangement and valuation fees, bank and legal charges means that interest rate insurance can be cheaper to provide than a remortgage. The absence of credit checks and valuations means it can be made available to all holders of a variable rate loan.
As interest rate insurance protects the holder from rising interest rates but does not raise their initial pay rate, if interest rates fall, the policyholder will see a benefit in reduced payments on their mortgage or loan when compared to a fixed rate alternative.
History (UK)
Monetary Policy Committee member Professor David Miles first highlighted interest rate insurance in the Miles Review in 2004 commissioned by Gordon Brown. Professor Miles suggested that it would provide greater security in housing finance. In the 2008 Budget, HM Treasury announced that the industry was ready to launch such a product.
In July 2008 MarketGuard launched an interest rate insurance policy RateGuard.
How Interest Rates Affect the Insurance Sector
Interest rates are constantly fluctuating, with real-time market changes influencing the likelihood of any sweeping interest rate changes, as well. In fact, when it comes to interest rates and insurance, interest rate risk for insurance companies is a significant factor in determining profitability. Typically, if interest rates increase, the value of a bond or other fixed-income investment will decrease. Although rate changes in either direction may affect the normal operations of an insurance company, an insurer's profitability typically rises and falls in concert as interest rates increase or decrease.
Interest rates and insurance are deeply linked, meaning any changes in interest rates affect the profitability of the insurance sector in multiple ways.
Because many insurance companies tend to hold assets such as long-term bonds, when interest rates increase, the opportunity cost of holding bonds at a lower-rate over time also increases.
Historical analysis shows that the overall trend is for the insurance sector to increase profitability when there are rising interest rates.
Affecting a Change in Assets
For one, any changes in interest rates can affect the assets of an insurance company. Because insurance companies have substantial investments in interest-sensitive assets such as bonds, as well as market interest rate-sensitive products for their customers, they are especially susceptible to any changes in interest rates that could affect their profitability. For example, let's say an insurance company is holding a ten-year, $1000 bond with a 3% coupon rate. If interest rates rise to 5%, then the insurance company will ultimately lose out and have a harder time selling the bond. However, the reverse could also be true, if the insurance company has locked in a higher coupon rate but market interest rates end up falling.
In a nutshell, when interest rates increase, the opportunity cost of holding bonds over a long period of time also increases, meaning the cost of missing out on an even better investment is greater.
Affecting a Change in Liabilities
Drops in interest rates can also 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.
Additionally, lower interest rates can also negatively impact an insurance company's risk profile as an equity investment, if analysts ultimately believe that the company may have difficulty meeting future financial obligations. Lower levels of equity investment typically 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.
