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European Life Insurers: Unsustainable Business Model

Low interest rates in the euro area pose substantial challenges to the life insurance industry. Insurers—particularly in Germany and Sweden—offer their clients long-term policies, sometimes more than 30 years, without holding assets of a correspondingly long duration. Moreover, many policies contain generous return guarantees, which are unsustainable in today’s low interest rate environment.

In 2014, stress tests showed European life insurers are vulnerable to a “Japanese-like” scenario.

Stress tests conducted by the European Insurance and Occupational Pensions Authority revealed the scale and urgency of this problem. This exercise showed that under a “Japanese-like” scenario with a prolonged period of low interest rates nearly a quarter of insurers were not able to meet their regulatory requirements (red line in Figure 1). As a whole, the industry was expected to have about 8–11 years before running into serious cash-flow pressures.

These results are more alarming than they appear

First, Europe is now facing a more severe scenario than the one used in the stress test, with interest rates that are significantly lower and expected to remain at low levels for some time (black line in Figure 1). Under those lower rates, two things are unclear: how many life insurers cannot meet their regulatory requirements today and how quickly this number is likely to increase over time.

Second, regulatory adjustments (the so-called Solvency II “Long-Term Guarantee” adjustments) help mitigate the short-term impact of stress but may not be realistic under industry-wide stress. Such adjustments help individual life insurers overcome temporary capital shortfalls but they become more problematic when the entire industry suffers from the same low interest rate environment for an extended period. For example, under a Japanese-like scenario, regulatory adjustments would make the value of insurers’ assets grow faster than that of their liabilities. But in a prolonged low interest rate environment, the present discounted value of future liabilities should rise by more than the value of assets as assets that mature will need to be reinvested at lower yields.

Some European life insurers are particularly vulnerable to failure

Mid-sized insurers with guaranteed returns and long-dated liabilities that are not matched by similarly long-dated assets face a particularly high and rising risk of failure. According to the European Insurance and Occupational Pensions Authority, more than half of European life insurers are guaranteeing a return to investors that exceeds the yield on the local 10-year government bond, thereby incurring undesirable negative investment spreads. In Germany, for example, despite a recent reduction to 1.25 percent on new products, the guaranteed return on total policies is about 3.2 percent, relative to a 10-year bond yield of about 0.3 percent.

The problem is compounded for insurers that suffer from large duration mismatches (when assets are shorter-dated than liabilities). Maturing assets need to be re-invested at the current lower yields and will not appreciate enough to offset the higher value of longer-term liabilities, especially when fixed at guaranteed rates. Germany and Sweden, which together accounted for about 20 percent of gross written premiums at the end of 2013, exhibit both duration mismatches of more than 10 years as well as negative investment spreads.

Life insurance markets are quite different between countries. In the United States, life insurance companies appear less sensitive to the risks associated with low interest rates, reflecting their product mix and the more favorable U.S. economic outlook. In the late 1990s, the Japanese life insurance industry was facing similar problems to the German and Swedish life insurers today, with high guaranteed rates and large duration mismatches. It took more than 20 years and the failure of eight mid-size insurers for the industry to lower its guaranteed rates and shorten duration mismatches.

Contagion to the broader financial system

The failure of one or more mid-sized insurer could trigger an industry-wide loss of confidence if it is perceived to reflect an industry-wide problem likely to spread to other institutions. The complexity of insurance business and limited financial public disclosure may also contribute to such contagion. The absence of a policyholder protection scheme or a set of common minimum standards for the entire European Union—which exist in Japan and the United States—magnifies such risks.

The high and rising interconnectedness between the insurance industry and the wider European Union financial system is another source of potential spillovers. The industry is the largest institutional investor with an exposure of €4.4 trillion to the European private sector (Figure 2). For example, severe cash flow pressures in one insurance company could trigger fire sales, forcing other institutions to recognize a mark-to-market price adjustment that could engulf the entire financial system.

GFSR April 2015 Blog Insurers Charts 2

What can policymakers do?

Regulators need to promptly tackle the challenges facing life insurers. They need to reassess the viability of guarantee-based products and work to bring minimum return guarantees offered to policyholders in line with secular trends in interest rates.

Regulators and supervisors should also seek to mitigate the damaging impact from potential difficulties in individual insurers. Introducing a more harmonized safety net, which protects policyholders, and ensuring adequate regulatory tools to deal promptly with weak institutions, would further increase the resilience of the industry. Finally, regulators should continue to improve transparency and public disclosure of life insurers. Despite the significant efforts by European regulators to strengthen transparency, including through the publication of comprehensive stress test results, it remains difficult to assess insurers’ true solvency position.