Low interest rates yet to truly test re/insurers – but challenges are imminent

The re/insurance sector is, however, trying various techniques to mitigate this affect. Many companies are taking more risk in their investments in an attempt to improve their investment income, according to the rating agency. In addition, property/casualty insurers are trying to engage in lines of business with better rates and reduce costs to offset lower investment income.

At the same time, life insurers are lowering the guaranteed rates of the products they sell and are shifting to unit-linked products, a mix of insurance and investment, which shifts more risk to the holder. But the situation for the sector is likely to get worse before it improves.

“Insurance companies continue to invest at yields that are lower than the yield they have on their existing portfolio, so the investment yield will continue to decline, at least in 2017 and probably in the future years as well,” says Benjamin Serra, vice president – senior credit officer, at a Moody’s April 26 press event in London.

The negative outlook comes despite interest rates having increased significantly since the third quarter of 2016, according to a Moody’s report titled ‘Global Insurance Despite Rise, Still-Low Interest Rates a Threat To Profitability’.

But nonetheless, interest rates globally remain very low and will continue to pressure insurers' investment returns in all regions, not least in Europe.

As a result, the rating agency expects the investment income of the global life industry to decline by $20-40 billion in 2017. This decline will, however, only result in a limited fall in life insurers' profits since it will be largely passed to policyholders through a reduction in credited rates.

P&C re/insurers face declining investment income

In contrast, non-life insurers' profits are directly impacted by declining investment income. Moody’s expects the investment income of the global non-life industry to decline by $5-15 billion in 2017, reducing non-life insurers' net result by 5 percent to 10 percent.

In search for higher yields, re/insurers are changing their investment strategy and accepting higher risk.

“They are investing in what are new asset classes for them,” Serra says. “They are looking at illiquid assets such as real estate, but most of the time it’s loans such as infrastructure loans or corporate loans,” he notes.

P&C re/insurers can arguably take more risk in their investment portfolio than life re/insurers.

“P&C [re/insurers] tend to go to the lower end of the investment grade spectrum and even non-investment grade,” says Antonello Aquino, associate managing director at Moody’s.

But the effect of the change in strategy takes time to show on the insurers’ balance sheets even for P&C insurers which have shorter investment durations than life insurers.

Another option for P&C re/insurers to offset the low interest rates is to increase prices for their services, but this might be difficult in the current soft market which is characterised by overcapacity.

“In markets like the UK we are seeing prices in property/casualty increasing, particularly in motor. But in other countries it is very difficult to raise prices, particularly in France and Italy,” Aquino points out.

In another attempt to protect their income performance, P&C insurers are reducing costs, according to Serra. And this is likely to continue. “In their results report insurers are saying that they are going to accelerate their programme of reduction of expenses,” Serra notes.

Last but not least, P&C re/insurers can look for ways to diversify into lines of business where rates are more attractive to boost profitability in the current soft market.

But this may not be so much of an option for primary insurers.

“Most of the non-life insurers we are dealing with are already diversified and present in many lines of business,” Serra says. Reinsurers, he continues, may have more flexibility to test new markets, reducing their exposure for example to cat risk in some markets where rates are particularly under pressure, and instead shifting to other areas with healthier rates.

Swiss Re, for example, has been shifting business towards tailored transactions, which are generally seen as more profitable than the traditional reinsurance business.

An opportunity to diversify and potentially improve underwriting profits could be cyber. But because it is a relatively young class of risk, re/insurers are still cautious, Aquino says.

While the impact of low interest rates is reflected faster in the results of non-life than life re/insurers in the form of falling investment income, the eventual consequences for life insurers may be more drastic.

Insolvency risk for life insurers on the rise

“For now, we expect more impact on the net results of P&C insurers, but the key difference is that for life insurers we are talking about potential insolvency risk and not only of profitability risk,” Serra explains.

The gap between durations of insurers' assets and liabilities has increased in several markets, in part driven by increased investments in riskier, but shorter term, assets. Therefore, the vulnerability of many life insurers to a scenario of prolonged low rates has increased, according to Moody’s.

“Life insurers can reduce costs, but the decline in investment income will be there for many years,” Serra says. “Most of the time, they cannot reduce prices,” he notes.

While P&C products are renewed every year, life insurance products are long-term and once they are sold, the insurer has limited options.

Life insurers have also tried to change their business mix, for example by selling more unit linked products, but it takes significant time for this to have a notable effect on the companies’ balance sheets, Serra notes.

Nevertheless, some cost savings may be achieved through automation.

UK life insurers, general insurers and brokers intend to invest heavily in IT, including blockchain and emerging technologies, according to the latest CBI/ PwC Financial Services Survey.

All three sectors expect staff costs to reduce, suggesting a continued move towards automation - using technology to streamline processes and play a vital role in ongoing cost reduction programmes.

But the cost cuts might not be enough to stabilize the business, particularly in countries where life insurers have high levels of guaranteed products in their portfolios such as Germany.

Other markets which Moody’s considers as holding “very high risk to profitability” because investment returns are already below or close to guaranteed rates are Taiwan and Norway.

M&A emerges as solution

One trend and a potential solution developing on the back of the interest rate pressure on life insurers may be more M&A, some driven by solvency issues and some by technology, according to Moody’s.

“What we are seeing in the UK is that there are investment funds and companies being set up to buy run-off portfolios at a high discount to their book value,” he notes.

Afterwards, the acquired companies or portfolios might be merged to reduce costs, he adds.

Bermuda-based Athene Holding, for example, has raised €2.2 billion common equity investment to support capital and reinsurance transactions in the German and European guaranteed life insurance run-off market.

Athene sees an ‘unprecedented need in the German and broader European market for equity capital and reinsurance solutions to support run-off portfolios and closed block reinsurance transactions, particularly those with high guarantees’, according to a statement.

M&A transactions related to technology may be another solution for life insurers to boost profitability, but these deals are likely to be smaller than those linked to solvency issues. “Companies are monitoring how technology is affecting their own business and if they see an opportunity to buy such a technology they will do so,” Aquino notes.

In a worst case scenario, however, the government might have to intervene to stabilise struggling insurers. In France, for example, legislation has been put in place by the government and the regulator to avoid potentially required fire sales of assets by insurers and control the systemic risk.