The implications of negative interest rates in Europe

Learning to live with low – and negative – interest rates has been a painful experience for many European insurers.

By Michael Leitschkis, Principal, Milliman.

The plunge into the uncharted territory of persistently low and negative interest rates in Europe has brought with it a raft of unforeseen consequences that have forced insurers to revisit age-old assumptions about investment strategies, product design, and risk modelling.

It has also made regulators nervous about the future solvency of life insurers locked into guaranteed returns on products, such as in Germany and Belgium.

In a stress test in the second half of last year looking at the risks posed by the continuance of the present low and negative interest rate regimes across Europe, the European Insurance and Occupational Pensions Authority (EIOPA) warned that 24% of life insurers could fail their solvency tests by the early 2020s if current rates persist.

None of the major policy decisions taken by central banks in response to the 2008 global financial crisis have been made with insurers’ top of mind, making these sort of consequences both unintended and unpredictable.

With European insurers in particular facing the added challenge of compliance with the Solvency II capital requirements, the old approach of de-risking investment portfolios by holding a high percentage of government bonds should be questioned. While this approach may lead to an attractive risk profile, it may also lead to inadequate returns. Insurers should be prepared to take on more risk so long as it is well managed, well modelled, and well understood.

Challenges and opportunities
Most equity markets have come out of the crisis with strong performances although, as always, the challenge is timing. Alternative asset classes such as infrastructure offer new opportunities, especially for matching long-term liabilities. However, they also bring with them new risks, both in terms of the capital matching requirements and political risk.

Seeking out high-yielding assets, such as property, adds to the credit risk of a portfolio, further complicating its risk profile. Risk managers need to be empowered to weigh the benefits of increased yield against the heightened risk profile.

On top of that there is now a clear divergence in interest rate policies with the U.S. Federal Reserve already on an upward curve, while in Europe and Japan they remain rock-bottom and could potentially fall even lower.

Competitive advantage
It requires robust, accurate, and responsive modelling techniques, especially to help identify and manage the downside risks. Get these right and not only will insurers be able to create and manage portfolios that produce returns above those delivered by a bond-heavy allocation, but they can also start to create competitive advantages from them.

This will be attractive to regulators and boards of directors, as it moves models beyond merely compliance to benefit, especially in the wake of Solvency II.

Model limitations
However, risk managers need to be aware of the limitations of their models. They need to be dynamic if upside returns and downside risks are to be properly measured and managed. Data input and review has to be a continuous process with high-quality real-time data being the ultimate key to reliability.

Once real-time models have been established as a key management tool, risk managers need to constantly challenge them and use them to test investment strategies and economic scenarios. They are an aid to decision-making and not a solution in themselves.

With the right models, and the right skills in place to use them effectively, insurers will be in a better position to shape their own destinies.


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