The economic situation appears to have reached a period of composure compared with last year, which is reflected by narrowing spreads on peripheral eurozone government debt. However, given that no permanent solution has been established to solve the uncertainties in the eurozone region, AM Best has continued to stress the balance sheets of rated entities against a renewed deterioration of the investment markets. It expects that companies should be braced for further economic shocks and should ensure risk management practices reflect the potential for volatile markets.
AM Best last updated the market on its stress tests in October 2012, in a special report entitled ‘European Non-Life Sector Faces Further Economic Uncertainty’, since when the economic situation in the eurozone has become more stable and the financial markets less volatile, notwithstanding recent market turbulence affecting various asset classes. The considerable improvement followed Mario Draghi, president of the European Central Bank (ECB), unveiling details of a new bond-buying programme in September 2012, aimed at easing the Eurozone’s debt crisis. In that same month, Germany’s constitutional court also reached a critical decision in support of the eurozone by permitting the establishment of the European Stability Mechanism (ESM).
The ECB’s pledge to purchase unlimited amounts of eurozone sovereign debt in the secondary market (known as the Outright Monetary Transactions (OMT) programme) was a new frontier. While the bank has not had to act on its promise of uncapped support, the action to create this facility has helped appease the financial markets. As sentiment in the eurozone has improved and calmness has ensued these past few months, insurers have seen their capital positions strengthen, helped by the increase of soft elements of capital such as unrealised gains on investments, or through successful debt issuances concluded at more favourable terms.
Latest Stress-Testing Results
Based on the latest stress testing of rated insurers domiciled in Europe, AM Best expects a period of stable ratings in the current environment. The stress-test results were based on company data for the 2012 year end and examined investments in Greece, Ireland, Italy, Portugal and Spain (GIIPS), as per Figure 1 below.
Both the insurance and reinsurance segments exhibit strong risk-adjusted capitalisation. However, due to its lower financial leverage and lower exposure to GIIPS investments, the reinsurance segment is more resilient as per the stress test and is better positioned than the primary insurance segment to absorb any future economic shocks in the Eurozone.
Companies Realign Investment Portfolios, Focus on Local Asset-Liability Matching
AM Best notes insurers and reinsurers have taken a range of actions to prepare them-selves in case of further market shocks and instability. Companies have been de-risking investment portfolios by diminishing exposure to peripheral sovereign debt and financial institutions. Upon liquidating these positions, they have realigned portfolios toward highly rated corporate bonds, cash and short-duration securities.
Large players operating in several countries within the eurozone have also realigned their government bond holdings to better match liabilities with local assets. These efforts to increase asset-liability matching that started at the end of 2011 were actively pursued during the first half of 2012, in conjunction with reducing exposures to GIIPS investments.
Further risk mitigation strategies have been developed in 2012, with insurers and reinsurers having constructed a range of their own euro-stress scenarios to develop adequate responses and be able to react promptly to significant shocks.
In the second half of 2012, tensions in the eurozone were deemed to have eased, and some rated insurers chose to reinvest into selected GIIPS securities. This movement was mainly observed toward Italian and Irish government bonds, for which the risk appeared reduced as a result of an increased confidence in these national economies. This was demonstrated by the countries’ reducing bonds yields, as per Figure 2 below. Conversely, Greece, Portugal and Spain are still considered to pose greater risks.
Rated Companies Take Additional Positive Actions to Improve Positions
Fairly strong 2012 results have supported rated insurers. Of the European companies AM Best follows, most benefit from good diversification of earnings, as much in terms of geographic spread as in terms of products. They tend to maintain a healthy balance between life and non-life business. Recently, many insurers have been actively reshaping their portfolios and increasing the share of non-life business, thus reducing their dependency on investment performance and interest rates.
In addition to producing robust technical performance in 2012, insurers benefitted from the recovery of financial markets that positively impacted soft elements of their capital such as unrealised gains on investments or Value of In Force, whilst recording relatively modest growth. Consequently, underwriting risks have not increased as much as capital resources have replenished in general, and risk-adjusted capitalisation has improved.
A number of rated companies have also been preparing for another freeze in the capital markets, as was last seen in 2011. To alleviate a potential liquidity crunch, they have proactively taken out large, multiyear credit facilities, usually with a syndication of highly rated banks. Many of these credit facilities were negotiated to exclude adverse covenants.
Life insurers that have traditionally offered with-profits products continue to reshape their portfolios. The low interest rate environment is making it fundamental for them to actively re-engineer their products to reduce guarantees and lessen investment risk. At the same time, life companies are placing greater emphasis on biometric products (largely protection offerings) and are increasingly relying on fee income from asset management activities that are far less capital intensive than traditional savings products.
A prolonged period of low interest rates remains among the biggest threats to life companies’ balance sheets. AM Best envisages that if this scenario were to persist over the medium to long term, the life sector, especially mutual life insurers, would likely be under negative rating pressure.
Downside Scenario Remains Until Fiscal Unions Emerge
The financial markets in Europe are experiencing a period of calm, although AM Best expects ongoing shocks to continue unless European Union (EU) policymakers reach a long-term solution to the eurozone imbalances. While actions taken in September 2012 have provided temporary breathing space, volatility is expected to continue. Policymakers realise that austerity measures alone cannot restore confidence, and therefore targeted stimulus activity is needed to breathe life into these stagnating economies within the eurozone.
Recently within the EU, there is a sense that policymakers are failing to act quickly enough to ensure lasting measures are in place. Frustration is leading individual countries – in particular Germany – to seek their own agreements with eurozone member countries on banking rules. A cohesive approach from all European countries and some form of fiscal unity is more likely to provide an enduring resolution to the eurozone’s troubles.
Eurozone countries will continue to face many challenges over the coming months. Many economies still struggle with high unemployment and stagnant economic growth. Headwinds such as the US Federal Reserve beginning to taper its quantitative easing programme – resulting in higher global interest rates – as well as economic slow-downs in countries such as Brazil and China, will add uncertainty to an already tenuous situation.
AM Best will maintain ongoing stress testing of rated entities’ balance sheets, given that shocks to the system are likely to continue. It is uncertain what form these shocks will take, but they seem inevitable. Rated insurers are better prepared for turbulent markets today, as compared with when the group last published the results of its stress tests in October 2012. That said, companies need to sustain their focus on risk management, capital buffers and liquidity in preparation for future stress events.
* This article originally appeared as ‘Best’s Briefing: Eurozone Stress Test 2013’, published by A M Best Co on 28 June 2013.
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