Squeezed investment returns in the ultra-low interest-rate environment will be one of the major operating challenges facing property and casualty (P&C) insurers in the year ahead, according to credit rating agency Fitch.

Investment yields in insurers’ investments fell again in 2015 and will likely fall further in 2016 unless long-term rates meaningfully rise, according to Fitch.

Fitch maintains a stable outlook on the US P&C sector in part due to strong capitalisation from lighter-than-average catastrophe events. However, the agency sees the industry’s revenue production as dogged by premium-rate competition in most segments and limited revenue growth in a still-recovering economy.

These factors, combined with weak investment yields, mean that P&C profits will be under pressure in 2016.

Declining interest rates have steadily eroded portfolio investment yields in high-quality, fixed-income securities for years.

In aggregate, the industry’s statutory portfolio yield (investment income/average invested assets) has declined by 1.4 percentage points over the last decade to 3.2 per cent at year-end 2014.

Lower investment yields mean there is greater pressure to produce underwriting profits to generate an adequate return on capital.

An analysis of statutory bond portfolios for a group of large insurers that represent over 60 per cent of industry fixed-income holdings shows that the coupon rate of maturing bonds in 2015 and 2016 is 4 per cent. This is well above ‘AA’ corporate index yields, currently at 2.7 per cent, and ‘A’ corporate index yields, currently at 3 per cent, according to Bloomberg. The effective duration on these yield measures is about 6.5 years.

“The Federal Reserve’s recent increase of the Fed Funds target rate, and anticipation of further increases in 2016, may promote some stabilisation of portfolio yields,” Fitch stated.

“However, how rate hikes affect credit fundamentals and the longer end of the yield curve is yet to be determined. It is also uncertain how new issue yields in the investment-grade corporate and municipal bond markets, favoured by P&C insurers, will react to future Federal Reserve actions.”

The rating agency added that the unrealised losses booked by insurers following the third-quarter plunge in equity values had led to a sharp decline in insurers’ year-to-date total investment returns.

“Within a group of 42 publicly held insurers that we follow, the total return on investments declined to 2.3 per cent for the nine months ending September 30, 2015 versus 5.3 per cent in the prior-year period,” Fitch said.

“P&C insurers’ total investment return is unlikely to meaningfully rebound in the near term as any upward interest-rate movement will reduce values of fixed-income holdings.

“Outsize equity returns that could offset the effect are not likely, given current market valuations and still mixed economic fundamentals.”