Last week, Munich Re announced strong investment returns but warned that low interest rates could impact results going forward. In an interesting interview with The Financial Times, Nikolaus von Bomhard, CEO of Munich Re, explains the challenges facing insurers due to easy monetary policies that have sent interest rates to record lows in many developed countries. Mr. von Bomhard expressed some support for a low rate policy intended to boost the economy but he sees broader implications, some of which are not widely discussed.

Insurers typically hold a large fixed income portfolio and low interest rates impact the investment returns available to meet future liabilities. However, low interest rates also reduce the discount rate used to calculate the present value of liabilities expected in future years which boosts the current value of these liabilities.

Mr von Bomhard said: “Many of the existing local accounting standards fail to show that some customer guarantees and options are increasing in value. If interest rates stay low for much longer, sooner or later things will get a little bit more difficult for some companies and you can’t see this in the accounts.”

Low interest rates reduce what insurers can earn from investments to meet pay-outs, but they also push up the assumed future cost of liabilities. Accounting rules do not always require this assumed higher cost to be shown on an insurer’s balance sheet.

While the impact of interest rates on calculating future liabilities is well understood by sophisticated investors, the story is often missed in the media and by those who do not read financial statements in detail. We present two other examples of the impact of lower interest rates on financial results.

**Lower Interest Rates Impact Berkshire’s Derivatives Liability**

Careful readers of Berkshire Hathaway’s recently released 10-Q report, discussed in detail on The Rational Walk, would have noticed an interesting statement regarding interest rates in the company’s disclosure on the equity index put option contract position:

In 2010, we incurred pre-tax losses of approximately $1.8 billion in the second quarter and $1.6 billion in the first six months on equity index put option contracts. During the second quarter of 2010, declines in major equity index values ranged from 12% to 15%

and we reduced our interest rate assumptions(emphasis added). As a result, the estimated values of the liabilities associated with these contracts increased.

In other words, Berkshire’s mark-to-market loss on the derivatives position was caused by both the decline in the equity index value and lower interest rates which had the effect of increasing the present value of the theoretical liability that would exist when the put option contracts expire.

**Lower Discount Rates Impact Pension Liabilities**

The calculation of defined benefit pension obligations represents another case where lower interest rate assumptions reduce the discount rate used to express future liabilities in present value terms. This causes future pension obligations to increase. Few investors pay much attention to the rate of return assumptions and the discount rate used in pension plan disclosures. However, incorrect or unrealistic assumptions can have the effect of understating true liabilities and inflating book values.

*Disclosure: The author of this article owns shares of Berkshire Hathaway. No position in Munich Re.*

I understand that “Low interest rates reduce what insurers can earn from investments to meet pay-outs.” But I am not quite sure how low interest rates push up the assumed future costs of liabilities.

Do lower interest rates push up future costs of liabilities due to the lower rate of compounding?

A policy priced at a certain interest rate will be profitable over its lifetime if interest rates hold or go up. But if interest rates fall, the principal will compound at a lower rate over its remaining lifetime, and will no longer cover payouts in the future.

Is that why low interest rates push up the assumed future costs of liabilities, or did I miss something?

Thank you,

Drew

In the calculation used to determine the present value of a fixed stream of liabilities years into the future, a discount rate must be used. The lower the discount rate, the higher the value of the liabilities when expressed in present value terms.

To take a simplified example, if a company has a lump sum pension liability of $1 million due in ten years, the present value of the obligation today would be $385,543 with a 10 percent discount rate but would rise to $463,193 with a 8 percent discount rate. In this case the formula used would be:

1,000,000 / (1+r)^10 where r = discount rate used

When re-reading the article, I think the following sentence may have caused confusion: “This causes future pension obligations to increase. ”

To be more clear, it should have read “This causes the present value of future pension obligations to increase.”