Nowadays everyone talks about how the low interest rates environment is affecting banks and their profitability: this is probably due to the fact that they are the most known players in the financial business, and therefore exposed to the mood of the market and the interest of the press. But actually they are not the only financial institutions that built their business on interest rates margins.
Insurance companies have their core business in collecting premia from clients and reinvest them in order to be able to fulfill future obligations; their favourite asset class is obviously the bond one, and especially government bonds, as they are less risky than stocks and therefore allow them to have more predictability and control on future cash flows. So let’s see in what “channels” low interest rates affect insurers.
The first and most obvious one, is the so called "income channel" whereby owing to the
sector's high exposure to long term fixed income assets investment income will suffer as the net cash flow from paid premia and maturing investments needs to be gradually reinvested at lower rates. Moreover, in Europe, the life insurance business is often characterised by the presence of products embedding financial guarantees, i.e. 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.
The second is the so called "balance sheet channel", that reflects how 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. 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.
It has also to be considered that, as already hinted above, starting from January 2016 European Insurers are officially under the Solvency II Directive, the translation of Basel into the insurance industry, which is aimed at making the industry overall more stable but obviously requires stricter capital requirements and brings with itself some uncertainty about the adaptation to the new regime.
All these factors have led to Insurance bonds suffering the worst start to the year of any major corporate bond sector in Europe. Investors who bought the iBoxx euro insurance index have lost money in 2016, the only sector among 12 in Europe to post a loss so far, according to Markit data. The index has returned minus 0.6 per cent, compared with a 1.2 per cent return for the iBoxx corporate index.
The trend is visible also in the U.S., where the forward P/E ratios both for Life and Property & Casuality Insurance Companies are lower than the Current ones (via Damodaran), underlying a decline in the forecasted growth. Moreover, the P/E multiple of the industry is historically positively correlated with the level of interest rates.
So, what should we expect from now on? Something is already moving: we are witnessing a shift towards illiquid assets such as infrastructure and real estate loans, but even the yields available in these areas have declined as demand has outstripped supply. As it can be seen it’s hard to make a clear cut prediction, but we can resort to the most recent stress test results carried out by EIOPA, in 2014, which state that “in a prolonged Japanese- low yield scenario, 24% of EU insurers would not meet their SCR (Solvency Capital Requirement, equivalent to 99.5% yearly VaR, n.d.r.) and certain companies could face problems in meeting their promises in 8-11 years’ time”. Therefore, while there are no immediate dangers, the hope is that the economy will recover and allow the tightening of monetary policies before Insurers will have to face hard times: we don’t want to find out how the bail out of a Global Systemically Important Insurer is going to work out.
Mattia Borello
Insurance companies have their core business in collecting premia from clients and reinvest them in order to be able to fulfill future obligations; their favourite asset class is obviously the bond one, and especially government bonds, as they are less risky than stocks and therefore allow them to have more predictability and control on future cash flows. So let’s see in what “channels” low interest rates affect insurers.
The first and most obvious one, is the so called "income channel" whereby owing to the
sector's high exposure to long term fixed income assets investment income will suffer as the net cash flow from paid premia and maturing investments needs to be gradually reinvested at lower rates. Moreover, in Europe, the life insurance business is often characterised by the presence of products embedding financial guarantees, i.e. 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.
The second is the so called "balance sheet channel", that reflects how 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. 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.
It has also to be considered that, as already hinted above, starting from January 2016 European Insurers are officially under the Solvency II Directive, the translation of Basel into the insurance industry, which is aimed at making the industry overall more stable but obviously requires stricter capital requirements and brings with itself some uncertainty about the adaptation to the new regime.
All these factors have led to Insurance bonds suffering the worst start to the year of any major corporate bond sector in Europe. Investors who bought the iBoxx euro insurance index have lost money in 2016, the only sector among 12 in Europe to post a loss so far, according to Markit data. The index has returned minus 0.6 per cent, compared with a 1.2 per cent return for the iBoxx corporate index.
The trend is visible also in the U.S., where the forward P/E ratios both for Life and Property & Casuality Insurance Companies are lower than the Current ones (via Damodaran), underlying a decline in the forecasted growth. Moreover, the P/E multiple of the industry is historically positively correlated with the level of interest rates.
So, what should we expect from now on? Something is already moving: we are witnessing a shift towards illiquid assets such as infrastructure and real estate loans, but even the yields available in these areas have declined as demand has outstripped supply. As it can be seen it’s hard to make a clear cut prediction, but we can resort to the most recent stress test results carried out by EIOPA, in 2014, which state that “in a prolonged Japanese- low yield scenario, 24% of EU insurers would not meet their SCR (Solvency Capital Requirement, equivalent to 99.5% yearly VaR, n.d.r.) and certain companies could face problems in meeting their promises in 8-11 years’ time”. Therefore, while there are no immediate dangers, the hope is that the economy will recover and allow the tightening of monetary policies before Insurers will have to face hard times: we don’t want to find out how the bail out of a Global Systemically Important Insurer is going to work out.
Mattia Borello