OREANDA-NEWS. Among the considerable operating challenges US property/casualty (P&C) insurers face heading into 2016, few are more significant than declining investment yields, says Fitch Ratings. Investment yields in insurers' investments fell again in 2015 and will likely fall further in 2016 unless long-term rates meaningfully rise.

Fitch maintains a stable outlook on the US P&C sector in part due to strong capitalization from lighter-than-average catastrophe events. However, the industry's revenue production is 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 140 bps over the last decade to 3.2% 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% of industry fixed-income holdings shows that the coupon rate of maturing bonds in 2015 and 2016 is 4.0%. This is well above 'AA' corporate index yields, currently at 2.7%, and 'A' corporate index yields, currently at 3.0%, 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 stabilization of portfolio yields. 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, favored by P&C insurers, will react to future Federal Reserve actions.

The persistently lower yields and unrealized losses on equities and alternative investments in third-quarter 2015, due to market volatility, have led to a sharp decline in 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% for the nine months ending Sept. 30, 2015 versus 5.3% in the prior-year period.

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