17 April 2013

Risk.net: National regulators ramp up efforts to combat low rate threat

There is a shadow hanging over Europe’s life insurers; an enduring challenge that threatens to decimate their reserves, sap their profitability and even plunge them into insolvency. This is the challenge posed by a prolonged low interest rate environment.

The European economy entered this treacherous world back in 2008, when the European Central Bank (ECB) first cut rates from 4.25 per cent to 3.75 per cent as part of coordinated action by the world’s central banks to buoy up the global economy in the wake of the collapse of Lehman Brothers. Five years on from that tumultuous event, the ECB rate is fixed at 0.75 per cent, with majority opinion predicting it will stay at this level until early next year at the earliest. For insurers, this sustained period of low rates acts like slow poison on their balance sheets. The discounting of long-term liabilities, based on real interest rates, means that the lower the rate, the more expensive these obligations are in today’s money.

In addition, many European firms, especially in Germany and Italy, sold products with high guarantees during the boom years, backing their liabilities with fixed-income assets that offered coupons of sufficient value to match their promises to policyholders. Low interest rates mean when these assets mature and are reinvested, insurers will struggle to match these guarantees. The longer the depressed interest rate environment persists, the harder it becomes for firms to make ends meet.

A stress test conducted by the European Insurance and Occupational Pensions Authority (Eiopa) in 2011, sampling 82 insurers, revealed that 5–10 per cent would face severe problems as a result of prolonged low interest rates in that their minimum capital requirements (MCR) would be breached.

However, supervisors are not standing by idly as Europe’s insurers fight to protect their long-term solvency. National regulatory authorities have been taking steps to combat the risk of low interest rates. And in March EIOPA waded into the fray, issuing an opinion acknowledging the threat to the European industry and promising to develop, with the help of national authorities, “an agreed framework for the quantitative assessment of the scope and scale of the risks posed by a prolonged low interest rate environment”.

The focus is now on those national supervisors that, in coordination with the insurers themselves, act as the first line of defence against the threat of low interest rates on firms’ solvency.

The first strategy being employed by supervisors is a closer scrutiny of interest rate risk. This is something several national authorities have already implemented, and several more are expected to do following EIOPA’s prompting. The second is an intense critique of firms’ product offerings, following warning signs that traditional savings products with high guarantees may no longer be viable if Europe suffers a lost decade of sluggish growth and depressed rates. Finally, there is the scaling-up of supervisor-led stress-testing as the authorities push firms’ business models to the limit to discover if, and when, they will break under the pressure.

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