European Life Insurers: Unsustainable Business Model

IMF Blog, May 5, 2015

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

2014 stress tests by the European Insurance and Occupational Pensions Authority revealed vulnerability to a “Japanese-like” scenario.
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.

Europe is 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).
Two uncertainties under the lower rates:
- How many life insurers cannot meet their regulatory requirements today.
- How quickly this number is likely to increase over time.
Solvency II “Long-Term Guarantee” regulatory adjustments:
- Help mitigate short-term impact of stress for individual insurers.
- May not be realistic under industry-wide, prolonged stress because:
- Regulatory adjustments could make the value of insurers’ assets grow faster than that of their liabilities under certain scenarios.
- 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.

Mid-sized insurers with guaranteed returns and long-dated liabilities that are not matched by similarly long-dated assets face particularly high and rising risk of failure.
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.
Germany example:
- Guaranteed return on total policies is about 3.2 percent.
- 10-year bond yield is about 0.3 percent.
- Recent reduction to 1.25 percent on new products.
Duration mismatches:
- Maturing assets need to be reinvested at current lower yields and will not appreciate enough to offset the higher value of longer-term liabilities fixed at guaranteed rates.
- Germany and Sweden exhibit both duration mismatches of more than 10 years as well as negative investment spreads.
- Germany and Sweden together accounted for about 20 percent of gross written premiums at the end of 2013.
Cross-country differences:
- United States life insurers appear less sensitive to low interest rate risks, reflecting product mix and a more favorable U.S. economic outlook.
- Late 1990s Japan faced similar problems to present-day Germany and Sweden; it took more than 20 years and the failure of eight mid-size insurers for the industry to lower guaranteed rates and shorten duration mismatches.

Failure of one or more mid-sized insurers could trigger industry-wide loss of confidence if perceived as an industry-wide problem.
Contributing factors to contagion:
- Complexity of insurance business.
- Limited financial public disclosure.
- Absence of a policyholder protection scheme or a set of common minimum standards across the European Union (unlike Japan and the United States).
Interconnectedness and market exposure:
- The industry is the largest institutional investor with an exposure of €4.4 trillion to the European private sector (Figure 2).
- Severe cash flow pressures in one insurer could trigger fire sales, forcing other institutions to recognize mark-to-market price adjustments that could engulf the entire financial system.

Reassess viability of guarantee-based products and bring minimum return guarantees offered to policyholders in line with secular trends in interest rates.
Seek to mitigate damaging impact from difficulties in individual insurers by:
- Introducing a more harmonized safety net that protects policyholders.
- Ensuring adequate regulatory tools to deal promptly with weak institutions.
Continue to improve transparency and public disclosure of life insurers:
- Despite significant efforts, including publication of comprehensive stress test results, it remains difficult to assess insurers’ true solvency position.

Source: European Life Insurers: Unsustainable Business Model — Reinout De Bock, Andrea M. Maechler, Nobuyasu Sugimoto, May 5, 2015.