The Optimal Interest Rate Scenario, Until Now

When I was running cashflow tests for life insurers, there was one scenario that was among the best for most insurers (life or otherwise).  The optimal scenario was a slow protracted rise in interest rates, say 1/2% per year for 10 years, or flat (no change).  Yes, with the slow rise, there will be unrealized capital losses, most of which will evaporate with time.  But excess cash flows will be invested at higher rates, raising the value of the firm.

I remember talking about this with people in the finance areas of other life insurers, and there was agreement — a slow rise in rates would benefit the industry as a whole.  Maybe annuity floor guaranties played into that as well.

But there are a number of parties that could not bear with the slow persistent rise.  Most governments of the world, including the US would find their budgets severely inverted if interest rates slowly rose and stuck.  As such, governments will do what they can to avoid such a scenario.  They don’t want to end up like Greece. That said, if they do end up there, expect that the governments hand losses off to bondholders, pensioners and/or medical care recipients.  The prime motive of a secular government is to survive, even if core goals are not achieved.

Thus at present, what is optimal for governments is to keep rates low for a long time.  Let savers get clipped, that government programs get paid for.  The risk here is that the bond market rebels and rates rise whether the government likes it or not.  But should that happen, and the government cannot pay on all promises made, it will force losses onto all long-term recipients of cash flows.

Perhaps policy will relax the strain on those in the private sector who have made long-term promises to pay, like pensions.  I would not count on that.  The government will be content with its own survival.