High Interest Rates Aren't Bad for Everyone

A penny could buy you a 'syrup of soot'... and a little more could protect your ship...

Although coffee was new to the United Kingdom in the 1600s, it became a fast favorite among merchants and other professionals. Brewed gritty, strong, and shockingly bitter, folks compared its taste to everything from old shoes and soot to mud and even feces.

It was a far cry from what you might buy at a modern-day Starbucks. Nonetheless, the drink took London by storm. By 1688, there were at least 80 coffeehouses in the city.

While they all served the same product, they attracted different customers. The shops were dubbed "penny universities" for their tendency to house debates on politics and science. And each became a little business hub for a different profession...

Lloyd's Coffee House, originally located just off the River Thames, catered to members of the maritime industry.

Captains, shipowners, and savvy financiers regarded Lloyd's as the best source in London for up-to-date shipping information. While they sipped their brew and reviewed the latest maritime news, these folks would also conduct some industry business...

Shipowners would approach captains about new ventures. Captains getting back from voyages would share information on pirate activity. And businessmen would approach shipowners... offering to protect their ships against the great unknown.

Today, we'll talk about this specific approach to ship protection... how it set the standard for modern insurance companies as we know them... and why the insurance industry is primed to flourish.

Ocean travel was dangerous in the late 1600s – and not just because of pirates...

Storms could sink ships, dragging their wares to the bottom of the sea. Entire crews could be wiped out by diseases like scurvy and smallpox.

Savvy businessmen realized they could make money by selling shipowners an assurance that they'd recoup their investments. Lloyd's quickly caught on to the burgeoning enterprise. It started renting out tables for these men to set up shop.

For a small fee, the businessmen would cover any losses if the ship didn't return. Most of the time, ships ended up coming back... and the businessmen made a nice profit for covering the risk. Every once in a while, though, pirates or bad weather would get the better of a voyage.

In those cases, the businessmen ended up out a lot of cash. That's when the popularity of Lloyd's came in handy...

You see, the businessmen realized they didn't have to cover an entire ship by themselves. It was smarter to spread out the risk by having several "underwriters" protect a single voyage. That way, if one ship failed to return home, it wouldn't make an underwriter insolvent.

This approach to ship protection became known as syndicated insurance. It rapidly became the standard not just in maritime insurance, but across all sorts of industries.

Over the next three-plus centuries, Lloyd's grew from its humble coffee shop beginnings into one of the biggest insurance marketplaces on Earth... and syndication became the gold standard for insurers to manage their risk.

Modern insurance companies still perform syndication in various ways. They spread out risk by doing business with as many clients as possible. Some offer multiple kinds of insurance to limit the chances of one catastrophe causing massive losses.

Yet, while syndicated insurance has been going strong for hundreds of years... investors have a short memory.

The market has forgotten how well this approach works... especially in interest-rate environments like today's.

You see, while higher rates are bad news for consumers, they're great for the insurance industry.

When insurance providers collect premiums, they don't just put that money in the bank. They reinvest that money... largely into fixed-income assets.

Returns on these investments are dependent on interest rates. So when rates are higher, every dollar of premiums an insurance company puts into investments should have higher returns.

Interestingly, a lot of insurers can also offset the swings in interest rates thanks to a savvy investment strategy...

In addition to corporate fixed-income assets, some also invest in high-yield opportunities.

However, high-yield investments are riskier than traditional investments. While they've helped insurance companies when rates were low... insurers don't need to take unnecessary risks today, when rates are elevated.

So not only are higher interest rates improving insurance providers' potential returns... they're also allowing them to reduce risk in their investment portfolios.

And with interest rates likely to remain flat for a while, insurance providers should continue to reap the benefits of their investment strategy.

Regards,

Joel Litman
July 2, 2024