Home Industry News Europe : low interest rates will harm life insurers

Europe : low interest rates will harm life insurers

0 0

Fitch Ratings says the European Central Bank’s 25bps interest rate cut today puts into focus the pressure on life insurers’ margins and earnings from low interest rates. Although insurers are exposed to long-term bond yields rather than the ECB’s short-term interest rates, the ECB’s rate decision means long-term interest rates are expected to remain low. Although not generally a threat to capital or existing ratings in the near-term, prolonged low interest rates will create challenges.

Life insurers are exposed to interest rate risk through investment leverage, product guarantees and policyholder options. Most sensitive would be insurers with a duration of liabilities in excess of assets and a high exposure to bonds that exhibit negative convexity ie, whose prices do not rise as much as most bonds when interest rates go down.

There has been sustained pressure on life insurers’ profitability for several years as their investment portfolios need to produce sufficient returns to meet the guarantees on their products. This problem is compounded for the majority of life insurers that have reduced the risk profile of their investment portfolios since the start of the crisis. Insurers have increased investments in AAA-rated government bonds and reduced investments in shares. This trend has accelerated this year as concerns have risen about the credit quality of Southern European government debt.

Although insurers practice sound risk management on interest rate risk, they may have to take on additional risk to cope with the effect of low returns. This could include investing in higher margin instruments, which may lead to deterioration in credit quality and potentially inadequate pricing relative to risk. Alternatively insurers may extend the duration of their asset portfolio. This could lead to asset and liability mismatches that increase liquidity risk.

Life insurers’ credit profile and exposure to low interest rates varies between countries. In Germany, the running yield on 10-year German government bonds (1.9%) is below the current guaranteed crediting rate for newly sold life insurance policies (2.25%). The yield difference appears even more severe, relative to the average guaranteed crediting rate of a life insurance portfolio of an average company, which is around 3.3%

At first sight this appears a negative margin on the life insurance business, suggesting that companies might not be able to meet the guarantees of their policyholders at current market yields. However, companies can still meet their guarantees at current market interest rate levels. For more information see Fitch’s 2012 rating outlooks for the insurance sector.

In France, there is still a significant gap between guaranteed interest rates on French life products (1% on average) and actual returns credited by French life insurers (3.4% on average for 2010), which gives them flexibility to adjust the bonus rates they pay for 2011. If substantial, this reduction in bonus rates would be beneficial for insurers’ profitability and solvency, both of which are suffering from the low yields on most Northern European government bonds and the deteriorated credit quality of several Southern European government bonds.

Source : Fitch Ratings Press Release