National regulators ramp up efforts to combat low rate threat

With protracted low interest rates being arguably the biggest challenge for life insurers, national regulatory authorities are taking steps to manage the threat posed to insurers’ solvency levels and ability to meet guarantees. Louie Woodall reports

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There is a shadow hanging over Europe’s life insurers; an enduring challenge that threatens to decimate their reserves, sap their profitability and even plunge them into insolvency. This is the challenge posed by a prolonged low interest rate environment.

The European economy entered this treacherous world back in 2008, when the European Central Bank (ECB) first cut rates from 4.25% to 3.75% as part of coordinated action by the world’s central banks to buoy up the global economy in the wake of the collapse of Lehman Brothers. Five years on from that tumultuous event, the ECB rate is fixed at 0.75%, with majority opinion predicting it will stay at this level until early next year at the earliest.

For insurers, this sustained period of low rates acts like slow poison on their balance sheets. The discounting of long-term liabilities, based on real interest rates, means that the lower the rate, the more expensive these obligations are in today’s money.

In addition, many European firms, especially in Germany and Italy, sold products with high guarantees during the boom years, backing their liabilities with fixed-income assets that offered coupons of sufficient value to match their promises to policyholders. Low interest rates mean when these assets mature and are reinvested, insurers will struggle to match these guarantees. The longer the depressed interest rate environment persists, the harder it becomes for firms to make ends meet.

A stress test conducted by the European Insurance and Occupational Pensions Authority (Eiopa) in 2011, sampling 82 insurers, revealed that 5–10% would face severe problems as a result of prolonged low interest rates in that their minimum capital requirements (MCR) would be breached.

However, supervisors are not standing by idly as Europe’s insurers fight to protect their long-term solvency. National regulatory authorities have been taking steps to combat the risk of low interest rates. And in March Eiopa waded into the fray, issuing an opinion acknowledging the threat to the European industry and promising to develop, with the help of national authorities, “an agreed framework for the quantitative assessment of the scope and scale of the risks posed by a prolonged low interest rate environment”.

The focus is now on those national supervisors that, in coordination with the insurers themselves, act as the first line of defence against the threat of low interest rates on firms’ solvency.

Although the economies of Europe are densely intertwined, each domestic market has its own unique characteristics that demand a tailored response for countermeasures to be effective. Yet some broad trends have emerged, which insurers would be wise to keep an eye on.

The first strategy being employed by supervisors is a closer scrutiny of interest rate risk. This is something several national authorities have already implemented, and several more are expected to do following Eiopa’s prompting. The second is an intense critique of firms’ product offerings, following warning signs that traditional savings products with high guarantees may no longer be viable if Europe suffers a lost decade of sluggish growth and depressed rates. Finally, there is the scaling-up of supervisor-led stress testing as the authorities push firms’ business models to the limit to discover if, and when, they will break under the pressure. 

Eiopa believes understanding the risk of low interest rates is half the battle towards eliminating it. In its opinion, the authority asks supervisors to quantify the risks arising from a prolonged low interest rate environment and intensify the monitoring of firms deemed to be particularly vulnerable. A number of regulators, both within and outside the European Union, seem to be on the same wavelength.

High guarantees
In Germany, both traditional reserving concepts and product offerings are being fundamentally rewritten in the expectation that low interest rates are here to stay. The German market is traditionally recognised as the land of high guarantees. Average guaranteed crediting rates on a typical German life insurer’s book stand at 3.25%, well above the current 1.4% yield on the German bund. With the prospect of low yields stretching far into the future, the federal regulator, BaFin, took action in 2012 to cut the maximum guaranteed rate for new products to a historic low of 1.75%.

However, BaFin is aware that this might not be enough. It has also introduced new safeguards and ramped up its supervision of firms in the last few years, conducting two surveys on low interest rates with German life insurers since 2009, and obtaining forecasts on a regular basis. “Next to intensifying analytics, BaFin is also applying a number of supervisory measures to stabilise an undertaking’s ability to service its obligations, such as imposing extra reserves to secure pay-out even under long-term adverse conditions,” says a spokesperson for the Bonn-based regulator.

One of these reserves, the Zinszusatreserve (ZZR), was introduced in 2011 to serve as an additional protection for policies embedded with high guarantees. The German Insurance Association (GDV) describes it as being a reasonable tool to help build up collateral buffers for periods of low interest rates, but warns that if conditions do not improve, the costs of the ZZR to the domestic market could reach €10 billion (£8.4 billion) in 2013.

Such a capital burden is hardly sustainable, let alone desirable, and BaFin is keen to explore other means of protecting firms’ solvency in the long term. Una Großmann, a spokesperson for the GDV in Berlin, says alternative guarantee concepts are being discussed, such as the ‘abschnittsgarantien’, which divides guarantees into several segments. “We are also discussing whether the actuarial interest rate, which determines the maximum guaranteed rate, should only apply for the vesting period and then be adjusted to present market conditions at the time of annuitisation,” says Großmann.

Over the next few years, Germany may well prove an interesting test case for other European countries anxious about expensive guaranteed products eating into the solvency of life insurers.

In Italy, guarantees are also high, but the spread on Italian treasury bonds – pushed wide by the eurozone crisis – means they remain manageable for now (see chart, page 28). A spokesperson for the Italian regulator, Ivass, comments: “We have some specific differences compared to the other markets [in Europe]. We have assets that meet guarantees and give a good return. For us at the moment, the risk is not as high as in other European countries. Nonetheless, we still pay attention to the risk because the prolongation of the low interest rate environment demands it.”

The more vexing issue troubling Italian insurers is asset volatility. Some market participants think this could be solved by incentivising firms to diversify their bond holdings in stressed scenarios, which they recognise could help resolve the problem of low interest rates in other countries.

Gianluca De Marchi, head of the financial and credit risk unit at Unipol Gruppo Finanziario in Bologna, explains: “A problem I can see in Italy but also probably in other countries is the concentration of their own country’s bonds [in their portfolios]. It would be interesting to have the possibility [in Solvency II] to have a more diversified portfolio. It could be useful for German companies to buy Italian government bonds to try and solve a part of the problem they currently have related to the low-yield scenario.”

However, backing German liabilities with Italian assets flies in the face of prudent risk management, and most market participants agree that Solvency II, with its focus on strict asset-liability matching, is unlikely to sanction the practice. Even De Marchi admits the concept is floated more out of hope than expectation.

The national authorities in Denmark and Switzerland are also keeping a close eye on the threat low interest rates pose to insurers’ solvency ratios, trusting in a ‘ladder of intervention’ where supervisory action is automatically triggered when firms’ own funds dip below predefined solvency levels.

Hansjoerg Furrer, head of quantitative risks management for the insurance division at Swiss regulator Finma in Bern, says this system is well suited to managing the challenge of low interest rates. “Should a company report a solvency ratio below 100% [of the Swiss Solvency Test] we have measures in place to intervene should Finma be of the opinion that the financial soundness of the insurance company is endangered. What we then do in such a case is we intensify the dialogue with the company, seek to find solutions, and ask what can be done in terms of risk mitigation and intragroup transactions,” he says.

Finma classifies distressed insurers according to three threat levels. Firms with a solvency ratio of 80–100% of liabilities are designated ‘yellow’, those with a ratio of 33–80% are ‘orange’, and those below 33% (the most at risk) are ‘red’. Each tier has its own associated set of actions that the insurer has to comply with. Firms in the ‘yellow zone’ must submit an action plan to Finma detailing how they intend to restore their solvency to safe levels and run a causal analysis of why their risk-based capital deteriorated in the first place. Those in the ‘orange zone’ need to put in effect a restructuring plan to bring their solvency ratio above 80% within two years.

Finally, those that dip into the ‘red zone’ are required to sell their insurance portfolio   in whole, or in part if they cannot raise the capital necessary to honour policyholder commitments.

A similar system characterises the Danish approach to supervision. The Danish Financial Supervisory Authority (DFSA) introduced the ‘traffic light system’ in 2011. This allows the DFSA to monitor the sensitivities of pension funds and life assurance companies’ capital to certain predefined market shocks, the ‘red light’ scenario. The stress scenario includes changes in interest rates both up and down.

“The companies report their exposures and risks every quarter to the DFSA, and the reported figures makes it possible for us to perform daily market surveillance based on daily market prices,” says Per Plougmand Baertelsen, Copenhagen-based director of the life assurance division at the DFSA.

The combination of scenario testing and frequent reporting ensures that firms are prepared for any interest rate eventuality. It is also an approach favoured by supervisors in the US, where insurers are also feeling the strain of low yields. Here, interest rate-based stress tests have long been part of the supervisory framework.

“State insurance regulations formerly prescribed seven deterministic scenarios for the potential path of interest rates in order to test the ability of insurers’ portfolios to withstand moderate shocks,” says a spokesperson for the National Association of Insurance Commissioners (NAIC), the US’s standard-setting and regulatory support organisation for the country’s network of state supervisors.

The so-called ‘New York 7’ scenarios included stress tests for up and down jumps of 300 basis points, and gradual increases and decreases of 500bp, the latter scenario becoming a reality during the past six years as Fed rates were repeatedly cut from a high of 5.25% in 2007 to 0.25% today.

In response to evolving risk management techniques, state supervisors chose to adopt stochastic scenario modelling requirements in 2009 to replace the ‘New York 7’, which oblige firms to use an economic scenario generator to test their business models against hundreds of interest rate eventualities.

“The use of stochastic scenario models allow for the change to the slope of the yield curve, as well as periods where the yield curve is inverted,” says the NAIC, adding that the new regulations give firms much greater flexibility then the rigid deterministic scenarios.

However, as is the case in Germany, monitoring and testing may not do enough to avert a rash of insolvencies in future years if the world economy maintains its feeble growth trajectory. Insurers around the world are revising their product offerings to reflect this new reality, and regulators are doing their bit to hurry others along.

Norway has gone further than others in actually seeking to define what insurers can, and cannot, offer policyholders via statute. Jan Hagen, Oslo-based adviser in the department of finance and insurance supervision at Finanstilsynet, says: “A proposal for new product legislation has been put forward in Norway, which aims to reduce interest rate guarantees and the impact of low interest rates.”

Product development
However, insurers have to walk a precarious tightrope when it comes to designing products to suit the new economic reality. Mark Burke, head of life insurance supervision at the Central Bank of Ireland (CBI) in Dublin, explains: “The challenge for product providers is to find a suitable product design that is profitable on the one hand and attractive to the end consumer on the other. [Firms] need to continually innovate from a product design perspective and ensure business models are as efficient as possible from a cost perspective.”

Others warn that stricter product regulation, while putting firms on sounder financial footing in the future, will do little to solve the problems of today. Finma’s Furrer explains: “The shift from very traditional savings products to more modern life insurance products where the policyholder bears the interest rate risk, such as unit-linked, still needs to take place. It takes a long time to shift the back book from these high-guarantee products to products that are less interest rate-sensitive.”

The course interest rates will take in future is clear to no-one. Eiopa is eager to test insurers’ resilience to a continuation of the current trend with a ‘stocktaking exercise’ in 2014. Whether this means a European-wide stress test, or another kind of action, is up for debate. Regardless, some national authorities think Eiopa is busying itself without due purpose.

Ivass, the Italian regulator, says that any future Europe-wide stress test run before the implementation of Solvency II could produce a skewed picture of interest rate exposure. “When you have a stress test harmonised for Europe you need to select the basis on which you apply it, and before Solvency II comes in those bases are not the same in the different countries. The risks can have a different shape,” says an Ivass spokesperson.

Even Eiopa admits that the differences between regulatory regimes across Europe mean that some firms feel the bite of low interest rates more keenly than others. These inconsistencies put the usefulness of a future stress test in doubt, says Janine Hawes, head of Solvency II at KPMG in London. “The opinion recognises that we have different regulatory regimes, some of them [account using] historic costs, some of them [using] market-valued costs, therefore the impact is different in different jurisdictions. We haven’t got a level playing field,” she says.

“At least with Solvency II we will have everybody working to a common rulebook but, for the moment, we have a range of different products, a range of different guarantees and a range of different philosophies underlying [them]. It’s not as if they can say we want every supervisor to test ‘x’ because ‘x’ may not be relevant in their local jurisdiction,” Hawes adds.

National supervisors readily boast that their own domestic exercises tell them all they need to know about the firms under their watch. For instance, since 2008 Norway’s insurance firms have reported quarterly stress tests that represent a ‘light’ version of Solvency II requirements. “The impact of current low interest rates, as well as the risk of a further reduction of interest rates, is captured in this regular reporting,” says Finanstilsynet’s Hagen.

The Netherlands’ central bank (DNB) is also placing firms under the microscope because of concerns that policy guarantees may be too high given current market conditions. “DNB is currently conducting a detailed stock-take that will give us a sharp and up-to-date view [of interest rate risk],” says Janko Gorter, senior economist at DNB, based in Amsterdam.

Meanwhile, Finma is currently in the process of developing new stress tests to account for more extreme scenarios, potentially including the possibility that interest rates stay depressed for much of the next decade. “We would like to come up with additional scenarios in future – ‘what if’ scenarios,” says Furrer.

“We believe scenario testing is a very important tool for risk management, and those we have in place already form part of firms’ quantitative requirements. We have a roadmap and agenda set for these new scenarios, but they are yet to be approved internally,” he adds.

So, what lies behind Eiopa’s desire to promote a harmonised response to the current threat? Most likely, it’s the weight of responsibility placed on the authority by its mandate to strengthen international supervisory coordination.

KPMG’s Hawes comments: “I suppose if they are sitting there with a hat on saying they need consistency across Europe, they want to make sure that the [national] supervisors are at least thinking about the impact of low interest rates.”

There is also the fear that those jurisdictions that account using historic costs will be in for a nasty shock once Solvency II comes into force, with its focus on market-consistent valuation. Eiopa will not want to face a slew of firms struggling with their solvency levels on the first day of the Solvency II’s implementation.

However, there can be no uniform solution for the whole of Europe, as the different experiences of Europe’s national supervisors testify.

Eiopa may try to shepherd them one way or another but, ultimately, each country will forge its own path out of the woods. “There’s no room for one single approach throughout Europe,” says the Ivass spokesperson, “but there is room to debate actions.”

It looks as if the debate will rumble on for some time to come.