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The insurer’s art of adapting to unprecedented economic times

Forsikringsrådgivning og teknologi|Investments
Insurer Solutions

October 30, 2019

How can European insurers achieve investment return targets and meet policyholder guarantees in this low interest rate environment?

The market environment we are living in, investing in, is unprecedented.

In France the 10-year government bond yield is negative for the first time. In Germany, the entire Bund market currently has negative yields. In the US, Alan Greenspan recently said there is no barrier to US treasury yields going negative. Across Europe as a whole, currently half of government bonds have a negative yield, with Italian government bond yields having reached an unprecedented low / negative level for 10 years bonds. Furthermore, unrealised capital gains buffers, which in previous years provided an opportunity to smooth out returns, have diminished drastically in the portfolios of insurance companies.

Looking forward, over the next two years our economists continue to forecast that the Eurozone and UK have a high risk of recession, while over five years our outlook is for downside risk to exceed upside risk.

Achieving investment return targets and hence meeting policyholder guarantees in this low interest rate environment (which is likely to be a prolonged one) is expected to be difficult and creates several questions and problems for European insurers. The main problems are:

  1. Because insurers typically hold a large amount of fixed income assets, low interest rates, together with diminishing spreads and a lower unrealised capital gains buffer, result in lower asset returns.
  2. On the liabilities side, low interest rates increase liabilities. This increase is compounded for insurers who have sold, and often still are selling, guaranteed products where the guaranteed interest rate is higher than current interest rates.

The combination of the two can threaten the solvency position of insurers and ultimately their profitability. And the impact is likely to be higher for small to medium sized life insurers with a large traditional fixed income portfolio (e.g. government and corporate bonds) and liabilities that include guarantees.

Whilst European markets have become familiar with this situation in recent years, some are now affected more severely than previously. On a positive note though, relevant experience has matured in recent years and tools have been developed allowing insurers to manage the impacts of low interest rates on the balance sheet with a mixture of tactical and strategic levers. For insurers, the key issues to consider addressing are:

  • Hedging of guarantees to reduce the interest rate risk from guarantees biting, particularly in a prolonged low interest rate environment or stressed market conditions – some of the tools used consist of more traditional asset hedging through the use of a portfolio of swaps and swaptions and/or more sophisticated hedges of the Solvency II balance sheet.
  • Reviewing investment objectives and constraints, ensuring these are clear and allow the insurer freedom to invest while remaining within its risk appetite.
  • Optimising the strategic asset allocation (SAA). This requires careful consideration of alternative asset classes that can improve returns efficiently (i.e. keeping portfolio risk and the Solvency Capital Requirement charge within risk appetite). Given that this is more effective for internal model companies, this could trigger renewed interest for partial internal models.
  • Improving asset and liability matching (ALM) through duration matching across the yield curve and thereby reducing the interest rate sensitivity of the balance sheet. The ALM exercise should be tied in with the SAA exercise.
  • Introducing agile instruments to analyse the impact of improved ALM and optimised SAA strategies on the balance sheet and capital.
  • Restructuring the product offering to be less capital intensive.
  • Implementing in-force management programmes.

Ultimately, there is not a single course of action that insurers could – or should – take in a low interest rate environment that will guarantee achieving their investment return targets. But with the right advice, and the right blend of the strategic and tactical issues considered above, insurers will be in the best possible position to mitigate downside risk and to capitalise on the upside.

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