“It is tough to make predictions, especially about the future” is a quote attributed to Yogi Berra and seems to come to mind when looking at European insurers. Of course pricing the likelihood of future events and selling option contracts (aka insurance) based on the probability of future events is the ‘bread and butter’ business of any insurance company. But as if the traditional business model wasn’t tough enough, the protracted low rate environment is posing major challenges to European insurance companies. In particular, the impact is expected to be highest for small and medium-sized life insurers with large government bond portfolios and high guarantees to policyholders where these guarantees are rigid and where contracts embed a long time to maturity. In this report we examine the impact of low rates on insurance company profitability and balance sheets and explore various ways that managements can combat the difficult macro environment. Similar to the conclusion in our earlier piece where we focused on the impact of low rates on banks, we do not portend to say low rates don’t matter they certainly do and it is harder for insurance companies to make consistently high return on equity (ROE) in a low rather than high rate environment. At the same time low rates are the ‘cards that were dealt’ for some time, and probably will continue to be yet for some time to come. Therefore insurance companies need to adjust to this environment and move on.
IntroductionThe ECB has analyzed the question of low rates and insurance as early as 2015 in their bi-annual Financial Stability Review. According to this publication, there is a general consensus that the low interest rate environment constitutes an ongoing secular risk for the European insurance industry . This is mainly due to two generic characteristics of insurers’ business models: (i) the large amount of fixed-term investments that insurers have on their balance sheet; and (ii) the strong influence of long-term interest rates on the discount rate of insurance liabilities. Moreover, in Europe, the life insurance business is often characterized by the presence of products embedding financial guarantees (e.g. instruments granting a minimum rate of return to policyholders). In times of low interest rates, this business model might represent a threat to the profitability and the solvency of life insurance companies, especially in countries where products with relatively high guaranteed returns sold in the past still represent a prominent share of the total portfolio.
It is, however, important to keep in mind that European insurers differ substantially in their investments and in the maturity structure of their liabilities, depending on their business strategy and geographical areas where they operate. In particular, the underwriting of insurance policies constitutes the core activity of any particular company, and the investment strategy is subordinated to underwriting needs, typically in the form of asset-liability management or matching techniques. Taking all these factors into account, it is difficult to have a clear picture of the final impact of low (long-term) interest rates, and this impact may, in any case, differ substantially across insurance companies and countries. Given the generally long-term nature of life insurance liabilities and the ensuing possibility to wind down assets over a reasonably long time should problems arise, low yields by themselves should not cause a major disruption in the sector. However, persistent low rates environment such as we have seen over the last ten years requires major adjustments in business models, especially for life insurers (as discussed below).
Insurance and low yieldsAccording to the ECB, Insurers are affected by low yields mainly through two channels. First, there is a slow-moving so-called "income channel" whereby owing to the sector's high exposure to long-term fixed income assets (see Chart 2) investment income will suffer as the net cash flow from paid premiums and maturing investments needs to be gradually re-invested at lower rates. The degree of vulnerability to the income channel is dependent on the business model of individual firms. Small and medium-sized, non-diversified life insurers are typically more exposed, in particular if they have sold policies with high levels of guarantees.
Second, the so-called "balance sheet channel" reflects that low interest rates will tend to have an impact on the balance sheet via a valuation effect, as low rates induce increases in the values of both assets and liabilities. A market-consistent valuation of assets and liabilities, such as prescribed in Solvency II, typically results in higher increases in the value of the latter when long-term yields decline because the magnitude of the assets invested in fixed-term instruments is a fraction of the total liabilities (see Chart 3). In addition, the duration of the liabilities is often longer than that of the assets. Thus, whereas the impact on profitability through the investment income channel takes time, a low-yield environment can affect the solvency of the insurers directly and immediately through the balance sheet channel, with those insurers with large duration mismatches being the most vulnerable to this channel.
Empirical evidence on the impact of long-term interest rates on the performance of insurers is scarce. But where tested, it seems that it is the volatility, rather than the low levels per se, of long-term interest rates that can increase the financial fragility of insurers. A few studies have also conducted more forward-looking analyses under the assumption of a continued and prolonged period of low interest rates. The studies all point to the likely negative effects that a protracted period of low interest rates would have on the solvency position of insurers. Intuitively, slow-moving insurance balance sheets suffer in times of rapid movements in interest rates, as any adjustment will necessarily take time. In the long term, insurers can resort to diverse adjustment mechanisms, the ECB concludes.
Last but not least, compressed ROEs driven by low interest rates on the numerator and the incrementally more punishing nature of Solvency II on the denominator (for both solvency requirements but also for less vanilla investments) have driven a wave of insurance intermediaries and managing general agents (MGAs), which are capital light alternatives to pure insurers. Therefore as the balance sheet part of the value chain has diminished this raises the question of whether it is better renting a balance sheet rather than owning one. Focus has therefore shifted to the remainder of the value chain – whether its customer acquisition, claims management and servicing, all of which are typically also technology driven. One could argue therefore that lower rates have stopped insurers from being complacent and living off their balance sheets, which may be a force for good / disruption in the long run.
How to fight back?
Investment and ALM strategiesMany companies have responded to the challenging investment situation by looking for alternative ways of increasing yield, such as moving down the credit curve, increasing duration or investing in alternative forms of assets. As per Moody’s 2020 Insurance Outlook , the squeeze on solvency and profitability “incentivizes them to take more asset risk.” This is readily visible in the deterioration in credit quality in their asset book: European insurers’ holdings of bonds rated below single A has risen by over one third in recent years (Chart 5), and Solvency II ratios have suffered as a result, according to a recent research report by Citi.
There is a general consensus that the problem is worse for Life insurers than for Property & Casualty (P&C) insurers, as Life insurers are apt to have a larger duration mismatch between assets and liabilities. Those with large annuity businesses, often featuring policies with guaranteed yields, the level of which was set when asset yields were significantly higher, are particularly at risk.
Typically the current yields of assets and liabilities are well matched, but every time existing assets mature and have to be replaced with new assets either the mismatch becomes worse or the insurers need to take on significantly more risk. In addition to this slow-moving ‘income’ channel, Life insurers also have a second ‘balance sheet’ channel, in which falls in bond yields cause an instantaneous deterioration in solvency if the duration of their liabilities exceeds that of their assets.
Of course, insurers are not sitting idle when faced with such a threat. Many companies have tried to adapt their business model, de-emphasizing their Life business relative to P&C. Almost all have tried to adjust through the liability side of the balance sheet rather than just through assets, by reducing the guarantee level on new products and/or abandoning guaranteed returns entirely. Lower guaranteed returns — often barely covering the cost of premia — have in turn made such products less attractive to customers in the first place.
Product liability strategiesProducts that have long durations and guarantees are most exposed to the volatility and profitability issues highlighted above. There may therefore be benefit in strategically repositioning the product mix, in essence lowering or removing guarantees, reducing dependence on savings products that derive profit from investment income and, where possible, marketing products that derive profit from mortality risk. In extremis, this may ultimately mean exiting some markets altogether and selling back-books.
Firms may also look to bundle additional services with insurance policies, such as wealth management and other advice. Companies may also consider diversification into other types of business such as non-life insurance or asset management business. Of course, banks are also facing the same market challenges and have been actively improving the bottom line by reducing expenses. This may include increased use of automation and outsourcing, as well as a direct result of reducing the product offerings.
Other business strategiesInsurers traditionally use reinsurance to manage their risk profile and balance sheet volatility. Reinsurers from different jurisdictions may be able to offer better terms for particular blocks of business due to the specifics of their own regulatory regimes. It should also be noted that reinsurers based in Switzerland, Bermuda and Japan have received full Solvency II equivalence under Article 172, although they may have other conditions that may be suboptimal such as no allowance for liquidity premia within the valuation basis.
At the current time, shares in financial institutions have fallen. Traditionally, insurance company shares have traded below embedded values. Companies cannot back their liabilities with own company shares but where there are spare funds that cannot be invested with high enough returns, share buy-backs could be considered.
How can FSC help?FSC’s solution is structured around a three step approach:
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