rates, which have become a frontline weapon in the battle to revive
flagging economies, appear likely to be around for a considerable
time. Charles Davis examines the implications for life insurers of
low rates which include not only a slump in income but potentially
negative regulatory pressures.
The worst of the credit risk
crisis may be in the past for the US insurance industry, but new
threats are emerging in the form of the lowest interest rates seen
in the country since the early 1950s, according to a new study by
Conning Research & Consulting.
The study, Life Insurance
Industry Investments: Investigating Interest Rate and Sovereign
Risk, examined investments for the period 2006-2010 for the
industry and for four market peer groups.
In addition to low returns on
portfolios composed primarily of fixed income securities, the low
interest rate environment may also cause problems with regulatory
requirements and hedging programmes.
“The primary story here is
that there was a bit of a breather in 2010, but there is more pain
ahead,” says Mary Pat Campbell, Con- ning vice-president for
“Sovereign debt and low
interest rates, combined, are really going to be the story as we
get further away from the recession.”
She added that on interest
rates, the Fed-eral Reserve Board has made it clear that it is
going to keep things the same.
“If the yield curve flattens,
you can’t just increase the maturity rates,” says Campbell. “You
are left with less flexibility and with people just chasing
“In such a risk-adverse
environment, insurers are constrained in what they can invest in,
and then they face real risk headwinds in what they actually can
To this mix must be added the
spectre of increased capital requirements, as principles-based
approaches to capital and reserving involve interest rate models
that project low interest rate environments.
Given that rates are unlikely
to rise in the near future the report states that insurers must be
prepared to deal with regulatory calculations that may include
scenarios involving low interest rates for very long periods of the
Hedging programme costs also
rise in a low-interest rate environments. Possible solutions
involve portfolio diversification and considering the risk-return
“However, as had been seen
with earlier attempts to improve yield, assumptions must be
considered carefully, lest assets be riskier than thought,” the
report notes. “Increasing duration is a consideration, and
lengthening bond portfolios have been seen among life
“However, there is a limit to
the benefits from increasing duration, as liquidity remains a
concern and locking in low rates for long periods will be
disadvantageous should rates rise rapidly.”
“Our analysis of life
insurers’ investment profiles through 2010 and into 2011 indicates
their response to the credit crisis – increasing cash and sovereign
debt holdings – exposes them to other risks, especially in light of
our current expectations about a long-term, low interest rate
environment,” says Campbell.
“The Federal Reserve’s August
decision in favour of long-term low interest rates creates a real
strategic problem for life insurers,” she continues.
“In addition to the obvious
issue of low returns on an asset portfolio composed primarily of
fixed income securities, the low interest rate environment may
cause other problems with regulatory requirements and hedging
“Approaches to dealing with
this challenge will require greater sophistication than ever
“Looking at the industry
through 2011 and beyond, the Fed’s commitment to a long, low-rate
environment is compounded by the downgrade of US sovereign debt,”
says Stephan Christiansen, director of research at
“Insurers must attend to
their risk profiles and consider their options. Looking forward,
with emerging dynamic capital and risk analysis requirements, our
modeling shows that lower interest rates may have particularly
pernicious effects on capital charges relating to some asset
classes in support of particular annuity products.”
As guaranteed crediting rates
begin to bite with no relief to be found in the general level of
interest rates, the industry may set out yet again in a quest for
yield, the report says.
“The experience of the
financial crisis, witnessing unprecedented market dislocations and
exploded assumptions regarding correlations and diversification
effects, will have made investment managers wary of seeking out
exotic asset classes,” the Conning report emphasises.
“There may be a need to dig
deeper in balancing risk and reward, as well as looking to
Ultimately, the report urges
insurers to adopt a more holistic approach to managing investment
strategy in a low interest rate environment.
Optimising performance, in
terms of return on surplus or expected present value of
distributable earnings compared to variability of that present
value, will require more complex modelling to understand the full
dynamics of the business.
Looking at assets by themselves
through scenarios will not suffice.
Using more complex models to
look at the expected value and variability of outcomes for
different investment strategies can provide a more full profile of
the risks and returns. The shortcomings of simpler approaches
become apparent in a difficult economic environment, calling for
more sophisticated analysis.
“To produce higher yield, to
move away from bonds and governmental debts towards more
sophisticated forms of investment, that requires more sophisticated
modeling,” Campbell says.
“You can’t simply increase
the duration of your portfolio or simply take on more risk, because
that’s not going to lift you out in a low interest-rate
Campbell adds that insurers
cannot look at asset portfolios in a vacuum.
“They have to also look at
interest rate stability and asset-liability mismatch, and people
have to do full modeling of their asset portfolio – stress tests on
both sides of the balance sheet will become standard,” she
“When you are in the life business, and your portfolio is
mostly fixed-asset, you had better be squeezing performance out of
everything you can.”