The extreme aversion that most reinsurers have for investment risk is leaving them vulnerable to the potential effects of a bursting bond bubble, say some experts.

David Flandro, New York-based global head of business intelligence for reinsurance broker Guy Carpenter & Co., said reinsurers' balance sheets were highly susceptible to interest rate increases given the heavy weighting of highly rated, low-yielding government bonds in their portfolios.

A 1.5% increase in inflation added to a similar rise in U.S. Treasury yields would have a multibillion-dollar negative impact on reinsurers, according to research by Mr. Flandro and his team.

The highest-rated sovereign bonds that dominate reinsurance firms' investment portfolios would lose value as interest rates climbed, shrinking balance sheets. At the same time, inflation would bring higher claims.

With the global economy afflicted by anemic growth and the U.S. Federal Reserve having vowed to keep rates at historically low levels into 2015, inflation is not widely seen as an immediate concern. However, many industry observers believe price increases are inevitable in the coming years, given the vast scale of central banks' quantitative easing around the world.

Mr. Flandro says a high-grade, fixed-income securities bubble is inflating, and that economists working for most of the biggest reinsurers are well aware of the risks this poses.

“Virtually all of the reinsurance sector owns one of a few asset classes in the majority — German bonds, Swiss government bonds, U.S. Treasuries, British gilts or Japanese government bonds,” Mr. Flandro said. “The corporate bond portfolios of reinsurers have also become more conservative in the last two years. The equity gearing of reinsurance companies' portfolios is at an all-time low as far back as we can measure it. This means that the sector is very susceptible to interest rates.

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“As interest rates go up, bond prices go down, causing mark-to-market losses and directly impacting reinsurers' balance sheets,” Mr. Flandro said.

While low interest rates have reduced reinsurers' investment income to a trickle, they have effectively boosted the industry's capital through the increase in bond valuations as interest rates fell.

“If 2011 was such a big catastrophe year, how was the reinsurance sector able to increase its capital?” Mr. Flandro said. “The answers are unrealized gains and reserve releases — it certainly did not come from underwriting. The question the reinsurance sector is rightly asking is: How much of those gains are truly tangible, and do we lose some of that capital if interest rates go up?”

Cliff Corso, CEO of New York-based Cutwater Asset Management, which has $32 billion of fixed-income assets under management, believes a more immediate concern for reinsurers should be a fall in bond values as investor appetite grows for riskier assets, though he appreciates the inflation risk is real.

“We're sitting on a powder keg of unignited liquidity,” Mr. Corso said. “The Fed's balance sheet is a very significant component of (gross domestic product) and of stock market capitalization. There's not a lot of velocity in this capital, but the potential does exist for unleashing that liquidity through the system, as and when velocity begins to pick up.

“The flight to quality poses the greater risk, in our view.”

The risk markets had been “on a tear” in 2012, he said, with strong gains in stocks and lower-rated bonds. Logically, this should have been accompanied by a rise in Treasury yields as investors veered toward risk assets. Instead, Treasury yields fell.

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“If we're right in our view that tail risk continues to be reduced throughout the globe over the next year and beyond, then we should expect the Treasury market to sell off,” Mr. Corso said.

“We shouldn't be surprised to see rates go 100 basis points higher. But I don't think the bubble will pop, because there are still tail risks and there's still a lot of debt to be (deleveraged) over the next few years. That will keep a bit of a lid on this Treasury market.”

Mr. Corso said tools for mitigating sovereign bond bubble risk included adjustment of duration and credit risk level within the portfolio, the sacrificing of liquidity for yield and the use of floating-rate instruments like collateralized loan obligations.

Arthur Wightman, Hamilton-based Bermuda insurance leader for PricewaterhouseCoopers L.L.P., said interest rate sensitivity and inflation had featured in reinsurance executive surveys by his firm.

“Owing to relatively conservative fixed income portfolios, reinsurers tended to weather the financial crisis a lot better than the broader financial sector, so it's interesting to see an environment evolve where strategies designed to reduce risk are manifestly creating increasing risk profiles for those reinsurers,” he said.