Challenges for Insurers Stemming From the Economic Environment and Negative Interest Rates
Issue: November 2016 |
Enterprise Risk Management
By Michael Morgenstern, Chief Financial Officer, General Reinsurance AG, Cologne
The publication of the most recent inflation estimates of 0.2% for August, or 0.9% without factoring in energy costs1, confirms that the developments of recent years are ongoing, with persistently low inflation in the Eurozone leading the European Central Bank (ECB) to extend its support measures.
Although 10-year federal bonds had an “impressive” yield of 80 basis points (BPS) at the start of the year, their yields fell below zero for the first time in the second quarter. Low energy prices are continuing to have a significant effect on inflation.
Most recently in March, the Executive Board of the ECB responded to the weak data by lowering interest rates to zero and increasing the «penalty interest» rate for depositing credit with the Central Bank to 40 BPS. Additionally, the Executive Board decided to expand its asset purchase programme from EUR 60 billion at present to EUR 80 billion per month, as well as to extend the programme by another six months to March 2017.2 Beyond these considerable support measures, significant media attention was paid to the alternative known as «helicopter money»3 even if the only response given was that it was a very interesting concept that is now being discussed by academic economists and that the Governing Council had not yet studied.4
Besides the ever-difficult general economic conditions with persistently high levels of debt owed by individual European countries and recurring fiscal surpluses in Germany,5 in the second quarter players on the capital markets were forced to consider the problems of the Italian banking sector and, in particular, the chronic budgetary problems suffered by Spain, Portugal and Greece.6
The difficult economic environment is compounded by a series of political upheavals, with the outcome of the referendum in Great Britain certainly the most cutting if not the most unique. Over the decade, the «European ideal» of maintaining continental peace through economic integration has turned into a mixture of political, economic and primarily monetary unions in which crucial aspects, such as domestic budgets and financial policy, remain within the purview of the individual states. In recent years the political focus has been on overcoming the Eurozone crisis, even if no sustainable solution has yet been found. In the recent past politicians have been faced with terror attacks, ongoing differences of opinion regarding the future direction of the EU,7 improving poll numbers and electoral gains for extremist parties in a number of countries and the unstable political situation in Turkey,8 all of which are increasing uncertainty amongst the public and in turn the financial markets.
The meeting of the world’s leading central bankers in Jackson Hole, Wyoming in the U.S., in late August 2016 was deemed «more exciting than the Olympics» by the chief economist of the bank ABN AMRO.9 The most eagerly anticipated point was whether or not Janet Yellen, the Chair of the Federal Reserve, the U.S. central bank, would announce an increase in interest rates in the year. Yellen did indeed hint at another change in interest rates in the remaining months of the year, yet noted that interest rates should not be expected to increase to more than 3% in the next few years.10
At the same time, the ECB is facing the question of whether or not further liberalisation of monetary policy would be wise or contraindicated in light of the persistently low rates of inflation; critics such as the former head of the Ifo Institute for Economic Research compare low interest rate policies to a drug.11 In a study published in summer, Deutsche Bank concludes that a reversal of monetary liberalisation is urgently necessary and that the interest rate for the Eurozone calculated using the Taylor rule had to be far above the current level.12 Opponents argue that negative interest rates should be an option for central banks in the future. These ways of thinking consider potential «obstacles», especially cash as an alternative for other investments, unattractive or even fully abolish them when considering models.13
Given the enormity of these uncertainties, we must wonder whether, like the Olympics, doping check-ups should be considered at this meeting.
Effects on the investment management of the insurance industry
The obvious question for insurers is what investment strategy is wise in this context. Ignoring largely symbolical shifts of investments into tangible assets or announcing a shift to cash,14 the insurance industry will remain invested in assets with fixed interest rates for the most part.
Other asset classes – such as the often publicly discussed infrastructure investments, shares and real estate – tend to play lesser roles. Besides the investments available on the market, supervisory considerations, such as the extremely high capital requirements of Solvency II, certainly play a role; for example, to many investors capital requirements of up to 49% for shares represent a less lucrative, albeit affordable alternative to risk-free investments (as they are defined by supervisory bodies) in European government bonds.
Additionally, the prices of shares and real estate in particular have increased significantly due to the dramatic interest rate cuts.
It is certainly possible to realise additional revenue by expanding spreads through fixed income investments with a higher credit risk. A wider range of currencies could also be added to the portfolio or its term extended. However, such approaches affect the risk profile of the insurer and therefore the necessary capital backing and risk management.
The development of interest rates on either side of the meeting of the Governing Council of the ECB on 8 September, for example, illustrates that these risks are real.
The lack of further interest rate changes by the ECB caused the reinvestment returns of German government bonds to improve. It is noticeable, however, that longer terms such as eight years caused returns to increase by an impressive 35% whereas two-year bonds increased by just 2%.
It is therefore clear that such a change in interest rates has a considerable influence on the fair value of the returns and in turn on the necessary amount of risk capital. In a rough sample calculation, the fair value of a fixed-income portfolio with a term of eight years reacts around 15 times more strongly to a change in interest rates than the value of a portfolio with a term of two years.
Considerations regarding risk management
The solvency ratios reported by German insurers at the end of the first quarter showed a decrease compared to day-one reporting.
In this regard we must assume that the decrease will continue over the course of the year in the life and health segments due to their high level of sensitivity to the persistently low interest rates.
It is certainly up to each company to decide how and to what extent an insurance company can increase its investment exposure. This is dependent on the qualitative effects as well as the quantitative effects. However, it seems problematic to make significant changes to the risk profile of the assets side in order to avoid making necessary adjustments to the underwriting side. The drastic reduction or even abolition of guarantees in the life business shows that the sector is taking on the challenge. On the other hand, we can also observe individual companies searching for growth in non-life insurance due to stagnating or receding life insurance premiums.17 However, this begs the question of to what extent growth in this field is not simply synonymous with pushing out other market players.
The combination of margin pressure and low interest rates will also affect changes in other lines of business. Examples given include losses with medium run-off periods for which larger economic provisions have to be set-up in order to pay them nominally.
Persistently low interest rates represent a key challenge to the insurance industry. Whereas in the past one could assume that investments sometimes made considerable contributions to corporate success, we now have to face the fact that loss reserves can only be covered with investments if the returns are negative.
In this regard, it is essential to focus on generating a price that is appropriate, given the risk. Cost-cutting measures should be combined with disciplined underwriting. The development of products in segments that are sensitive to changes in interest rates is of enormous importance. Besides increased focus on biometric risks and the offering of products with higher potential returns and lower guarantees, the management of sales costs will be crucial in a world where customers are increasingly dependent on digitisation and networking.
The ongoing digitisation of the economy,18 the “shared economy” and the growing significance of so-called FinTech companies have made it necessary to constantly test and develop business models if businesses want to successfully overcome the stranglehold of negative interest and the general “20 per cent on everything except...”.
A move away from the world of capital markets flooded by central banks is not currently in sight. Scepticism is abundant, regardless of whether – and if yes, when – the ECB will announce the further liberalisation of monetary policy. In our current market place, we are reminded of a few lines from Indiana Jones and the Last Crusade:
[After commandeering a plane]
Professor Henry Jones:
I didn’t know you could fly a plane.
Indiana Jones: Fly, yes. Land, no.19
To us it appears doubtful that central bankers know how they can safely end what they started.
Therefore, the price at which risk can be insured is an issue that can be driven by interest-related expectations even less than ever.