European insurers dig deeper as negative yields persist

Generating sufficient returns in today’s low and negative interest rate environment is a complex and growing challenge. Finding sustainable solutions that enable firms to meet their liabilities while remaining profitable has become a key priority, one that will shape the landscape for years to come. 

Low to negative central bank interest rates and negative-yielding debt across vast swathes of the global fixed income markets are putting the insurance sector under enormous pressure. Whether current conditions constitute a new normal remains to be seen. What is clear is that a reversion to historic interest rate and yield levels will not happen any time soon, forcing insurers to take decisive action to adapt and protect their businesses.

Negative yields are widespread and prolonged

Interest rates have been steadily decreasing over the past 20 years.

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Source: Bloomberg

The yield on the benchmark 10-year US Treasury recently slumped below 0.5%, surpassing the previous record low of 1.32% set in July 2016, with predictions it could hit zero. Meanwhile, “the vast majority of bonds in Europe and Japan—upward of 30% of all investment-grade debt in the world—carry negative yields to maturity,” notes Manulife Investment Management’s most recent Global Intelligence report[1]. When inflation is taken into account, the volume of negative-yielding debt in real terms balloons still further.

Select sovereign bond yields (%)

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Source: Refinitiv, Manulife Investment Management, as of November 2019.

And investors should expect low to negative rates to persist for some time, according to the Manulife report. “Inflation rates remain stubbornly below policy targets across many developed markets, with massive debt burdens, globalisation, aging demographics, and technology-related price deflation all applying downward pressure. Aging demographics alone may imply structural changes to inflation and yields, with lower levels of household formation on the one hand and greater demand for fixed-income assets on the other.”

European insurers’ ability to counteract the decline in interest rates depends on a range of factors, including the local regulatory environment, their product mix, and nature and construction of the underlying insurance contract portfolio. Responses have varied as a consequence. But urgent action is clearly a top priority across the industry.

Life insurers: reserves provide a temporary fix

In Southern Europe, life insurance policies resemble regular savings contracts, with relatively short durations and lower guaranteed minimum returns. By contrast, in Northern Europe they tend to be more akin to pension contracts, having much longer durations and higher life insurance rate guarantees. For instance, German insurers historically committed to hard guarantees over a contract’s lifetime, even though performance was built over time.

As interest rates have declined over the last two decades, insurers’ ability to offer a hard guarantee on the performance of policyholders’ savings or pension plans has become increasingly difficult. In a negative interest rate environment, providing guarantees has become nigh-on impossible.

In France and Germany, insurers’ ‘profit sharing reserves’ – profits that belong to policyholders and are distributed over time – has enabled insurance companies to continue paying rates to policyholders that do not fully reflect the discounted value of the yields currently available. But this is a temporary fix.

Markets’ tax frameworks may offer some respite. Under certain regimes, policyholders are incentivised to remain in their life insurance contracts for tax more than performance reasons. Where this occurs, insurers have greater scope to reduce the guarantees.

Investment approaches are a further consideration. Pre-Solvency II, some life insurers were weighted towards shorter-dated assets, believing at the time that rates would rise. Parts of the industry suffer from a ‘duration gap’ as a result (where assets have shorter maturities than liabilities). Under Solvency II, balance sheets are marked-to-market, so any mismatch in duration generates volatility in the balance sheet and their own funds, increasing insurers’ sensitivity to the slump in yields (see our article on Solvency II for a more detailed discussion of the regulation’s impact in the current environment).

One mitigating factor is that life insurers have tended to hold long-dated assets, with their investment portfolios built gradually over time. Since firms only need to re-invest a small portion of their portfolio each year to cover new business and maturing investments, lower interest rates affect only that part of the portfolio.

Nevertheless, the “too low for too long” interest rate environment will eventually eat into portfolio yields to a point where it may become difficult for some insurers to pay their guarantees – especially given policyholders with generous guarantees tend to hold on to their contracts. As rates drop, underlying liabilities and exposure to interest rates will therefore grow.

In the kind of negative rate environment we are seeing today, even contracts with a zero guarantee are unprofitable for insurers. When new savings are invested into negative-yielding bonds, insurers have to report a loss upfront, before charging investment management fees. As a result, French insurers that cannot tap into their profit-sharing reserve to subsidise new business have no choice but to stop writing these contracts. 

P&C insurers and reinsurance providers focus on cost containment

Property and Casualty (P&C) insurers tend to have shorter-dated liabilities. Auto and home insurance are usually yearly contracts with potential intra-year claim payments. For these insurers, the investment horizon is shorter and the regular reinvestment process means the drop in yields affects investment performance much quicker. Insurers active in “long tail” lines – such as employer liability, environmental and construction insurance contracts – are often less exposed as their investment horizon can be significantly longer.

For P&C insurers, the technical result (i.e. the gross profit on premiums received) forms the main profit source, with investment gains providing additional revenue. When the return on investment drops, insurers will first try to increase the technical profitability (i.e. reduce their so-called “combined ratio”). The more successful an insurance company is in containing costs and the risks in its client portfolio, the higher its technical result will be. 

In contrast to life insurers, P&C insurers invest on behalf of their shareholders (not policyholders). In theory, they can afford to invest in riskier assets to offset some of the drop in yield. There are two caveats though:

  1. Solvency II imposes a capital charge, with riskier assets attracting higher charges. Insurers will only invest in riskier assets if the yield increment more than offsets the capital charge.
  2. Some lines can be structurally loss-making (if technical profitability is negative) because of pricing competition or other commercial reasons. Where investment returns become the sole source of profit, insurers will tend to invest more of their assets in safe investments to secure part of the revenues.

Reinsurers also tend to have shorter liabilities (depending on their life reinsurance or P&C reinsurance mix). Their investment patterns and sensitivity to low rates are therefore similar to P&C companies.

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Available levers to adapt to the interest rate environment

Despite the challenging outlook, insurance companies have multiple ways to minimise the impact of falling interest rates.

Diversify assets

To bolster the yield on their general account without augmenting the level of risk, insurers have been:

  1. Investing in USD assets (converted back into EUR using cross-currency swaps).
  2. Increasing allocations to illiquid assets to capture the illiquidity premium paid to long-term investors.

Alternative assets hit a new high in 2019, with the latest Preqin figures showing global AUM surged to $10.3tn in 2019[2]. Private equity and private debt have been particularly popular with yield-hungry investors, with both reaching record levels. And allocations seem set to rise further, with McKinsey’s Private Markets Annual Review noting that limited partners are under-allocated versus target levels by more than $500 billion in PE alone[3]. Real estate – which generated a median annualised net return of 10% in the three years to June 2019 – also remains popular, with 83% of investors surveyed by Preqin intending to commit as much or more capital to the asset class this year.

Many insurers are familiar with some illiquid assets, such as real estate and loans, but the picture is mixed. Dutch insurers, for example, have long invested a significant portion of their portfolios in mortgages. The asset class may be new though for other European insurers, which lack the in-house expertise to manage them.

Likewise, institutions may have less experience and exposure to private equity, private credit and certain real assets. Less sophisticated insurers will be at a major disadvantage, as they do not have the expertise and often find it isn’t profitable to build in-house teams given the size of the investments.

Lower the guarantees

Reducing the guarantee is feasible for new contracts – provided competitors follow the same strategy. It becomes more difficult when a large portion of the competition is comprised of mutuals with significant reserves (undistributed profits) they can use to subsidise rates.

The ability to lower guarantees for existing contracts depends on the contract wording, especially if it includes a pre-defined guarantee over a certain period. Even if the contract allows for modifications, this can be difficult to implement in practice. In countries where insurance contracts are one of the primary pension products, cutting payments to policyholders risks a public backlash.

Grow the unit-linked product offer

Life insurance companies are actively exploring unit-linked and hybrid contracts. Plain vanilla unit-linked policies offer no guarantee on either performance or the amount invested. Sales are sensitive to market volatility and retail investors tend to surrender their contracts in market downturns.

Demand for hybrids has grown. In hybrid contracts, part of the amount invested is protected (usually 70%-80%) and they may include a minimum return guarantee. Bigger insurance companies have the firepower to make these contracts appealing to policyholders. For example, some are investing in illiquid assets to boost returns without increasing the risk.

Divest underperforming portfolios

A more radical response has been to re-insure or sell the portfolio to an ‘insurance consolidator,’ which is often backed by a private equity sponsor. Several transactions have taken place in recent years. For example, Athora acquired Delta Lloyd Deutschland in 2015, Aegon Ireland in 2018 and Generali Belgium in 2019, while Viridium Group – a Cinven/Hannover RE joint venture – bought German life insurer Generali Lebensversicherung in 2018. 

Outsource

Faced with falling investment returns, cutting costs is one of the main levers insurers can employ to improve profitability. Much has already been done to reduce staff headcount and rationalise underlying organisational structures, so insurers are examining external solutions to streamline their processes.

The shift into illiquid assets, financial market globalisation, tough and growing regulatory requirements, data overload, demand for real-time position monitoring to keep up with 24-hour markets, and client demands to improve the user experience are all putting unprecedented pressure on institutions’ in-house operations.

Rather than devote ever-increasing investments to headcount and technology, Christelle Ybanez, Head of Strategy and Planning for asset owners and asset managers at BNP Paribas Securities Services, explains that “outsourcing to a custodian can enable insurance companies to take advantage of a third-party provider’s operational expertise, accuracy, speed, scalability, risk control, compliance readiness and service quality at a cost often difficult to beat in-house.”

For large insurers with an in-house trading desk, outsourcing execution and transaction management can capture efficiency gains through the conversion from a fixed to a variable cost “pay as you trade” operating model. Outsourcing securities financing and collateral management can generate yield on dormant long-only investment portfolios. Delegating the custody and portfolio administration associated with the core investment management activity can reduce operational risk and headcount. And instead of investing heavily in skillsets and tools adapted to multi-asset class investments, insurers can discuss their options with asset servicers who have developed middle office outsourcing capabilities including analytics and reporting tools dedicated to the analysis and monitoring of illiquid assets like that of private equity and debt.

Creating a sustainable business model

For insurers with ongoing (often long-term) liabilities to meet, generating sufficient returns in today’s low and negative interest rate environment is a complex and growing challenge. Finding sustainable solutions that enable firms to meet their liabilities while remaining profitable has become a key priority, one that will shape the landscape for years to come. Further cost cutting and outsourcing of non-core activities will likely become increasingly important strategies as Europe’s insurers adjust to this new paradigm. 

[1] Generating income in the era of negative bond yields, John F. Addeo, Manulife Investment Management, 21 January 2020, https://insight.manulifeim.com/global-intelligence/en-us/generating-income-in-the-era-of-negative-bond-yields

[2] Alternatives in 2020, Preqin, 6 February 2020, https://www.preqin.com/insights/special-reports-and-factsheets/alternatives-in-2020/26665

[3] Private Markets Annual Review, McKinsey, 1 February 2020, https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/mckinseys-private-markets-annual-review