Ultra-low interest 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 insurance research.
“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 yield.
“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 invest in.”
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 simulations.
Hedging programme costs also rise in a low-interest rate environments. Possible solutions involve portfolio diversification and considering the risk-return profile.
“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 insurers.
“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 programmes.
“Approaches to dealing with this challenge will require greater sophistication than ever before.”
“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 Conning.
“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 asset-liability matching.”
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 environment.”
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 says.
“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.”