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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

A life insurer in India holds long-dated liabilities and invests mainly in government securities. The yield curve inverts sharply, with 2-year yields above 10-year yields. Which statement is the most accurate for the insurer?

Short assets earn more now, but against long liabilities they create reinvestment risk if short rates fall later. Long bonds match the liabilities but yield less today. Inversion neither removes this trade-off nor guarantees that long rates will rise.

  1. AReinvestment of maturing short-term assets is at lower rates than the long-term yields, so margins improve
  2. BInversion has no effect since liabilities are valued at a fixed rate
  3. CThe insurer can lock in the high yields only by buying 2-year bonds, which removes all reinvestment risk on long liabilities
  4. DLocking in 10-year yields gives lower returns than short bonds today, while holding short assets against long liabilities exposes it to reinvestment risk if short rates later fallCorrect
  5. Inversion implies long-term interest rates will definitely rise

Explanation

With an inverted curve, long bonds yield less than short ones, tempting the insurer to shorten assets. But long liabilities then require reinvestment at future short rates, which may be lower, so reinvestment risk arises. Buying 2-year bonds does not remove this risk, and inversion does not guarantee rising long rates.

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