27 February 2017

ECB: A stochastic forward-looking model to assess the profitability and solvency of European insurers

Authors develop an analytical framework for conducting forward-looking assessments of profitability and solvency of the main euro area insurance sectors. The model highlights the potential threats to insurers solvency and profitability stemming from a sustained period of low interest rates.

This paper has a twofold aim:

• on the one hand, to develop an analytical framework for financial stability analyses in which the effects on the profitability and solvency of the main euro-area insurance markets of different financial market scenarios as well as different features of the balance sheet of insurance companies can be investigated in a forward-looking manner;
• on the other hand, to conduct a quantitative forward-looking assessment of the effects that a persistent low interest rate environment has on both the profitability and the solvency of the main euro area insurance sectors.

More specifically, in this paper, authors model the balance sheet of an insurance company encompassing both life and non-life business and they calibrate it using country level data to make it representative of the major euro area insurance markets. Then, they project this representative balance sheet forward under stochastic capital markets, stochastic mortality developments and stochastic claims.

Against this background, this paper proposes an analysis that takes into consideration key elements of the insurance business which vary across markets. Authors calibrate the insurers balance sheet at country level as to introduce heterogeneity both in the business mix, e.g. life and non-life, and in business practices, e.g. duration mismatches. In fact, a more diversified business portfolio as well as better matching strategies have beneficial effects in terms of risk mitigation, which in turn positively influence both the profitability and the solvency of the insurance company.

The results of this work suggest that under a theoretical scenario featuring a protracted period of low interest rates, insurers more exposed to products with financial guarantees display a marked reduction in both profitability and solvency over time.

As expected, authors find that the specific local regulation and the applied business practices with respect to certain products (e.g. the minimum return guarantees and duration mismatches) are key drivers of both the profitability and solvency and of insurers.

Their model also highlights the importance of business portfolio diversification. Indeed, as the business portfolio becomes more diversified and less concentrated on interest rate sensitive business, e.g. financial guarantees, both profitability and solvency improve. The model also displays interesting results when it is extended to the group case, i.e. the insurers balance sheet includes both life and non-life business lines. In fact, under the assumption that within a group, capital can be managed and transferred to different lines of business to improve the solvency situation, negative spillovers may emerge. As the non-life business has in general a limited exposure to financial risk, its profitability and solvency position are less affected by the low interest rate environment, but largely depend on the performance of the underwriting portfolio.

Full working paper

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