Over the past 20 to 30 years, interest rates have been trending downwards in many markets. Ten-year government bond yields in the US, the UK, and Germany have fallen below 2% and Japanese 10-year yields have been below 2% for more than a decade as a result of the prolonged economic difficulties there.
While the current low levels of interest rates help over-indebted corporate borrowers to deleverage their balance sheets, not everyone benefits in this environment. Savers are hurt most and insurers – life insurers in particular – are the institutional savers who suffer most from low investment yields.
It is estimated that about US$25,500bn in funds, or about 12% of global financial assets, are managed and invested by the global insurance industry. Thus a reduction of one percentage point in the investment return results in lost investment income estimated at US$255bn per year, or about 6% of global premium income.
The negative effects of low interest rates on insurers appear slowly in the balance sheet because only current premium income, a fraction of total investments, is invested at market yields. This delayed impact on the investment portfolio gives insurers time to react but, conversely, can also tempt them to wait in the hope of a reversal in interest rates and delaying required actions.
Lessons from History
A look at the history reveals that many interest rate scenarios are possible. These range from decade-long low interest rates, to a mean-reversion situation where interest rates fluctuate around their long-term averages and a sudden spiking of interest rates, driven by inflation.
To take a closer look, as mentioned nominal interest rates have been generally trending downwards over the past three decades. In the early 1980s the yields on 10-year government bonds peaked at around 15% in the US and about 11% in Germany, driven by oil price shocks and a loose monetary policy that led to a sharp increase in inflation. It took years of very high central bank interest rates and a severe recession to bring inflation under control, finally leading to a sustained decline in inflation expectations and lower long-term government bond yields. Much of the decline in nominal bond yields over the three decades since then can therefore be attributed to the sustained decline in inflation and a vigilant monetary policy.
However, real interest rates (nominal interest rates minus inflation expectations) have also trended downwards over the same period. Real 10-year government bond yields in the US and the UK are estimated to have declined, from levels of around 4% in the late 1980s and 1990s to close to zero recently.
While there is no consensus as to what have been the drivers behind the decline in real interest rates, the two most frequently-mentioned reasons are:
- A savings glut in which an excess of savings, particularly from emerging economies, has faced a lack of global investment opportunities leading to a decline in real interest rates. According to this line of argument, the decline in the real interest rate is regarded as a natural consequence of shifts in supply and demand that keep the market for funds in equilibrium.
- A loose monetary policy, in which very low central bank interest rates have prevented market interest rates from rising across the yield curve. In 2010 and 2011, for example, both the US Federal Reserve (US Fed) and the Bank of England (BoE) tried to lower long-term government bond yields by purchasing bonds directly from private market participants. According to this view, the low real interest rates observed in financial markets are seen as a deviation from the equilibrium or natural real interest rate.
The Effect on Insurers
While interest rates affect all insurers and their treasuries, not all lines of business are affected to the same degree. Short-term business can usually be re-priced on an annual basis as policies are renewed or replaced, thereby making its sensitivity to interest rate fluctuations marginal. By contrast, interest rates have a huge impact on long term lines of business, where investment income is a major source of earnings – as in life insurance. Savings products are the most exposed to interest rate risks, because investment income is a key source of profit and policyholder behaviour can foil insurers’ hedging strategies that rely on reasonably accurate predictions of future cash flows. Investors in insurance firms from other treasuries can also be adversely affected.
Even within the life insurance savings business, there are huge differences in interest rate sensitivity. An international comparison of savings products reveals that sensitivity is highest where guarantees are rigid and the duration of the business is high. In addition, certain policyholder options exacerbate insurers’ sensitivity to interest rates, including the possibility of withdrawing money without penalty, increasing payments or sums insured at original terms, or extending the term of policies.
How Insurers can Manage their Profitability
Non-life insurers can periodically attempt to re-price their products. For life insurers, solutions to restore profitability for their in-force business are more limited because policy terms cannot be changed, although they can optimise their asset management and hedging as well as streamline their operational costs. They can also offer to exchange existing policies for new products with similar benefits while being easier to hedge.
New life insurance products should be designed in a way that interest rate risks can be effectively hedged. Regulators can help in facilitating this. Moreover, the life industry will need to address a fundamental question: how do the economic costs of guarantees offered compare with policyholders’ willingness to pay for them? In a world in which the economic valuation of insurers’ balance sheets is gaining in importance, pricing also needs to be market-consistent. This implies that guarantees which are difficult to hedge, yet create little value for customers at the point of sale (PoS), must be eliminated.
The current low interest rate environment provides the opportunity to address these issues and create a win-win situation for insurers, their treasuries and policyholders, ensuring that all parties are better prepared for any future rate scenario.
We have been witness to a series of significant security events recently around payment execution, from Leoni in Germany through to ABB in South Korea and SWIFT in Bangladesh to name a few of the major headlines.
A decline in the return on capital employed of globally listed companies over the last decade has been noted in recent EY and PWC reports. This is despite businesses taking an increased focus on balance sheets since the financial crisis in 2008.
The revised Payment Services Directive regulation, regarded as one of the most disruptive in Europe’s financial services sector, will begin to make an impact on January 13, 2018.
The cost of compliance efforts for banks has increased exponentially in recent years. This is especially true for those banks that are active in the global trade finance domain, where the overwhelming expectation is for compliance requirements to become even more complex, strict and challenging over time.