Insurance businesses in a low interest rate environment

The Supervisory Statement released by the European Insurance and Occupational Pensions Authority (EIOPA) on Wednesday, 18 March is a timely reminder of the potential negative side effects of low or negative interest rates on both life and non-life insurers.

EIOPA considers the current ultra-low interest rate environment to be one of the most important sources of systemic risk for insurers in the coming years.  Low interest rates put pressure on the profitability of insurance companies, in particular life insurers with expensive policy guarantees to cover (for example, guaranteed annuity rates and guaranteed investment returns) and non-life insurers which rely heavily on investment returns to cover claims.

EIOPA concludes that the current low interest rate environment is significantly impacting the EU insurance sector in terms of asset allocation, reinvestment risk, profitability and solvency.  Weak economic conditions suggest that interest rates are likely to remain low in the euro zone for some time.

As a result of the low interest rate environment, life insurers are changing their product strategy to focus more on products with no guarantees such as unit-linked products.  This has been linked to a shift in strategy towards “integrated wealth management”, with life insurers offering a complete suite of pensions and other savings products, often with significant investment in the digitalisation of the customer interface.  The other significant trend in recent years has been the sale of legacy businesses with expensive guarantees to consolidators.

What effect do low interest rates have on insurance companies?

Low interest rates have an impact on both the asset and liability side of an insurer’s balance sheet:

• Increase in the present value of the insurer’s liabilities

On the liability side, low interest rates lead to an increase in the present value of the insurer’s obligations, given that insurance liabilities are discounted using risk free rates.  EIOPA considers that this increase in liabilities has not been offset by increases in the value of investments.

• Decrease in investment income

Declining interest rates will normally have positive effects on the value of existing fixed-income investments, but will also generally lead to a decrease in investment income, making it harder for an insurer to match outgo on claims and the cost of guarantees under pensions and other savings’ products.

• Acceptance of greater investment risk: the search for yield

The decrease in investment income has led some insurers to change their asset allocations towards higher-yielding but riskier and less liquid assets, for example infrastructure, loan portfolios, property and private equity as well as equities.  Since the start of the last financial crisis, banks have tended to retreat from these investments, creating opportunities for insurers but competition and pricing has increased in recent years.  In Q2 2019, insurers were buying more equities than government or corporate bonds.  But perhaps the most surprising statistic is that in Q2 2019, insurers, in particular life insurers, bought approximately EUR 32 billion of government bonds with a negative yield.

• Increase in reinvestment risk of assets

An analysis of maturing bonds shows that the yields of the replacing bonds were on average significantly lower when compared to yields on the bonds they replaced.  EIOPA estimates that the drop in the weighted average yield from a government bond portfolio would be 50% over the next 10 years.  The drop is similar for corporate bonds.

• Impact of an economic downturn

If credit spreads rise due to a loss of confidence in the ability of borrowers to service their debt obligations, then the value of fixed-income portfolios held by insurers could fall.  This may be offset through lower liability values if the risk free rate also increases.  The fall in value of the fixed-income investments would however mean that yields would increase.  A sharp increase in yields on fixed-income investments may also trigger an upsurge in lapses and surrenders by policyholders whose policies are not linked to fixed-income investments and who want to take advantage of higher yields available on fixed-income investments, leading to liquidity problems for insurers.

EIPOA’s recommendations to National Supervisory Authorities

EIOPA makes a number of recommendations to National Supervisory Authorities (NSAs) as follows:

Short-term actions

• NSAs should intensify the monitoring and supervision of insurers with greater exposure to the low interest rate environment.
• NSAs should discuss with undertakings actions they could take to improve their financial resilience.
• NSAs and undertakings should pay special attention to pre-emptive recovery and resolution planning to reduce the likelihood and impact of insurance failures.
• NSAs should broaden the analysis of the low interest rate environment and also consider the potential build-up of systemic risk.

Medium to long-term actions

• NSAs should identify whether there are any tools or powers are missing from their current toolkit and request them from the relevant (national) authorities.

Authorities have a wide range of powers but they tend to be soft in nature (for example, the ability to require insurers to undertake scenario testing, intensifying monitoring, increasing reporting requirements and issuing recommendations and public statements).  In fact, most tools are for identifying and monitoring risks – authorities are more limited when it comes to actual powers to manage risk.

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